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A Guide To ROI and IRR Why You Need Both 1676559970

This document provides a simple guide to understanding ROI (Return on Investment) and IRR (Internal Rate of Return). ROI shows the return in dollar amounts, while IRR shows ROI adjusted for time. Both metrics are needed to fully understand the return of an investment. The document explains how to calculate ROI and IRR using examples. It notes that IRR can be misleading if used alone since it annualizes returns, and recommends comparing ROI and IRR side-by-side to evaluate investments. A common target for private equity deals is 3.0x ROI over 5 years at a ~25% IRR.

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Sam Nam
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16 views15 pages

A Guide To ROI and IRR Why You Need Both 1676559970

This document provides a simple guide to understanding ROI (Return on Investment) and IRR (Internal Rate of Return). ROI shows the return in dollar amounts, while IRR shows ROI adjusted for time. Both metrics are needed to fully understand the return of an investment. The document explains how to calculate ROI and IRR using examples. It notes that IRR can be misleading if used alone since it annualizes returns, and recommends comparing ROI and IRR side-by-side to evaluate investments. A common target for private equity deals is 3.0x ROI over 5 years at a ~25% IRR.

Uploaded by

Sam Nam
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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A simple guide to

ROI and IRR


BY CHRIS RELLY
ROI
Shows my return in dollars

IRR
Shows my ROI adjusted for time

You need both to understand


the return of an investment.

BY CHRIS RELLY
Let’s start with the easier one:

ROI means “Return on


Investment”
(Btw, this is often called MOIC or “Cash-on-Cash”)

BY CHRIS RELLY
If I invest $100 and get back $200

my ROI is 2.0x = ($200 / $100)


If I invest $100 and get back $300

my ROI is 3.0x = ($300 / $100)

BY CHRIS RELLY
But now let’s introduce

TIME…
If I make 2.0x in one month,
great!
But if I make 2.0x in 100 years…
not so great.
So I need a way to measure my
ROI over TIME as well.

BY CHRIS RELLY
That’s when IRR comes in.
IRR means…

"Internal Rate of Return,"


and while IRR is often used
alongside NPV & DCF analysis,

I want to simplify it further

BY CHRIS RELLY
Let's say IRR means the

“annualized rate of
return for an investment.”
In other words, "what percent
did I make PER YEAR?"

10%? 25%?

BY CHRIS RELLY
Let's go back to the examples from earlier...

2.0x in one month: 409,500%


(confusing)

2.0x in 100 years: 0.7%


(makes more sense)

This is where IRR can be misleading


and why it's common for private
equity folks to say "you can’t
spend IRR."

BY CHRIS RELLY
IRR calculates an ANNUALIZED percent
return, so

big returns in the early days


can skew the numbers
If I crush it in the first month, my IRR
formula says, "whoa! you’re going to keep
this up all year? Nice!"

BUT IN REALITY IT WON’T


PLAY OUT THAT WAY.

BY CHRIS RELLY
The IRR starts to feel more "palatable"
as time goes by, for example:

2.0x after 6 months: 300%


2.0x after 1 yr: 100%
(↑ I doubled up in one year, and IRR is an
annualized number, so it's 100%)

2.0x after 2 yrs: 73%


2.0x after 3 yrs: 44%
2.0x after 4 yrs: 32%
(↑ see how it drops off steeply & then smooths out?)

BY CHRIS RELLY
And this is why you need

Without the other, they


can both be misleading.

So you compare
them side-by-side:

“As of [date] my ROI was


[X] and my IRR was [Y].”

BY CHRIS RELLY
Note, this gets trickier once you factor in
timing of cash flows...

If I invest $100, get $120 back in


month 2 and $80 back in month 6,

I've still made 2.0x, but my IRR will


be much higher than 300%.

(↑ conversation for another time, but in


Excel, you can use the XIRR function to
navigate this).

BY CHRIS RELLY
So how do I think about it in my head? I
just compare any private investment to
the stock market.

If I can open a brokerage account, pay


basically no fees, take my money out
anytime, and make 7-10% on average...

Then locking up my capital in an illiquid


private investment (that has fees)

must have a MUCH higher IRR than 7-10%.


That premium needs to compensate me
for the additional risk I'm taking.

BY CHRIS RELLY
Which leads me to a common
private equity metric...

Most deals target 3.0x over 5


years at a

~25% IRR.
This is an initial goal post set in
most models.
(↑ much higher than the market to
compensate for the risk)

BY CHRIS RELLY
THANKS,
I’m CHRIS.
What I do:
• Financial Modeling Education
• M&A / FP&A Consulting

BY CHRIS RELLY

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