ROI vs IRR: Which Investment Metric Should You Use?
ROI and IRR both measure investment returns but differ in how they handle time. Learn when to use each, with worked examples and common pitfalls.
ROI (Return on Investment) and IRR (Internal Rate of Return) are both investment metrics, but they serve different purposes. ROI is simple and widely understood. IRR accounts for the time value of money and is better for comparing investments with different timelines and cash flow patterns.
ROI vs IRR: The Definitions
ROI measures the total return of an investment as a percentage of the original cost. It does not account for when cash flows occur or the time value of money.
Formula
ROI = (Net Profit ÷ Investment Cost) × 100
Example
You invest £50,000 in equipment. Over 3 years it generates £75,000 in net profit. ROI = £75,000 ÷ £50,000 × 100 = 150%.
IRR is the discount rate at which the net present value (NPV) of all cash flows from an investment equals zero. It accounts for the timing of cash flows, making it more accurate for multi-year comparisons.
Formula
IRR is calculated iteratively: it is the rate r where ∑[Ct ÷ (1+r)^t] = 0, where Ct = cash flow at time t
Example
Same £50,000 investment returning £20,000/year for 3 years + £15,000 in year 4. IRR ≈ 28%. This means the investment earns the equivalent of 28% annually, compounded.
Key Differences
- 1ROI ignores the time value of money; IRR explicitly accounts for when cash flows occur
- 2ROI is a simple percentage of total return; IRR is an annualised rate equivalent
- 3A project with higher ROI does not necessarily have higher IRR, a quick 3-year project may have better IRR than a 10-year project with higher total ROI
- 4IRR requires a series of periodic cash flows; ROI just needs total investment and total return
When to Use ROI vs IRR
Use ROI for simple, quick comparisons and marketing ROI. Use IRR when comparing investments of different durations, for capital allocation decisions, or when timing of cash flows matters significantly.
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Common Mistakes to Avoid
Using ROI to compare investments with very different timelines, a 100% ROI over 10 years is far worse than 100% ROI over 2 years
Interpreting IRR without a hurdle rate, an IRR of 15% is great if your cost of capital is 8%, but inadequate if it is 20%
Not accounting for reinvestment assumptions, IRR assumes interim cash flows are reinvested at the IRR rate, which may not be realistic
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Frequently Asked Questions
Which is better: ROI or IRR?↓
Neither is universally better. ROI is simpler and better for quick comparisons or single-period returns. IRR is more rigorous for multi-year projects where the timing of cash flows matters. Sophisticated investors use both.
What is a good IRR?↓
A good IRR depends on the cost of capital and risk. For real estate, 15–20% IRR is typically good. For venture capital, 25–35%+. For corporate capital projects, 12–20%. The key is exceeding your weighted average cost of capital (WACC).
What is the difference between IRR and NPV?↓
NPV (Net Present Value) tells you the absolute value of an investment in today's money. IRR tells you the effective annual rate of return. Both use discounted cash flow analysis. Use NPV to decide whether to invest; IRR to compare investment options.
Can ROI be negative?↓
Yes. A negative ROI means the investment lost money. If you invested £10,000 and got back £7,000, ROI = (£7,000 − £10,000) ÷ £10,000 = -30%.
What is marketing ROI and what is a good benchmark?↓
Marketing ROI measures the revenue or profit generated from marketing spend. A common benchmark is 5:1 (£5 return for every £1 spent). E-commerce businesses often target higher. Below 2:1 typically means marketing is unprofitable.