ROI or IRR? The key metrics every investor must master to evaluate their projects

When it comes to deciding whether to invest in a project, many investors find themselves at the crossroads of choosing between two financial indicators: the Net Present Value (NPV) and the Internal Rate of Return (IRR). Both tools are essential for determining whether an investment will generate profits or losses, but here’s the challenge: sometimes they give contradictory answers. A project may appear more profitable according to the IRR, but the NPV shows a different reality. That’s why understanding what each measures is crucial for making smart decisions.

NPV vs IRR: The battle of financial metrics

Before diving into technical details, it’s important to grasp the key difference:

• NPV answers the question: How much money (in real terms) will I earn with this investment?
• IRR answers: At what annual percentage does my money grow in this project?

Confusion arises because a project with a high NPV doesn’t always have the most attractive IRR, and vice versa. This happens because they calculate profitability in different ways and under different assumptions.

Deciphering the Net Present Value (NPV): From theory to practice

NPV is fundamentally simple: it takes all the cash flows you expect to receive in the future, adjusts them to their present value (considering inflation and the cost of waiting), subtracts the initial investment, and tells you whether the result is positive or negative.

Why bring the future to the present? Because 100 dollars today are not worth the same as 100 dollars five years from now. The “discount rate” is the tool that performs this conversion. It’s like applying a progressive discount as the years pass.

The accessible formula for NPV

NPV = (Cash Flow Year 1 / ((1 + Discount Rate) ^ 1) + )Cash Flow Year 2 / ((1 + Discount Rate) ^ 2( + … + )Cash Flow Year N / )(1 + Discount Rate) ^ N( - Initial Cost

Although it may seem complicated, in practice it means:

1. Project the income for each year
2. Divide each by ((1 + your discount rate) raised to the number of years
3. Sum all the results
4. Subtract the initial investment

Interpretation:

• Positive NPV = The investment generates more money than it costs
• Negative NPV = The investment costs more than it generates

) Real cases: Positive NPV that builds confidence

Imagine you want to invest $10,000 in a project that promises to generate $4,000 each year for five years. You use a discount rate of 10% to reflect risk.

Year-by-year calculation:

• Year 1: 4,000 ÷ 1.10 = 3,636.36 dollars
• Year 2: 4,000 ÷ )1.10(^2 = 3,305.79 dollars
• Year 3: 4,000 ÷ )1.10###^3 = 3,005.26 dollars
• Year 4: 4,000 ÷ (1.10)^4 = 2,732.06 dollars
• Year 5: 4,000 ÷ (1.10)^5 = 2,483.02 dollars

NPV = 3,636.36 + 3,305.79 + 3,005.26 + 2,732.06 + 2,483.02 - 10,000 = 2,162.49 dollars

Result: It’s a good project. You would generate over $2,000 in net value.

( The dark side: Negative NPV as a warning sign

Not all projects are gold. Consider investing $5,000 in a certificate of deposit that will pay $6,000 in three years, with an 8% annual interest rate.

Present value of the future $6,000: 6,000 ÷ )1.08(^3 = 4,774.84 dollars

NPV = 4,774.84 - 5,000 = -225.16 dollars

With a negative NPV, you are losing money before the period ends. The investment doesn’t even cover its initial cost adjusted for inflation.

Choosing the discount rate: The art behind the numbers

Here’s one of the biggest challenges of NPV: what discount rate to use? There’s no single answer, but useful approaches include:

Opportunity cost: What return could you get from a similar investment? If you can get 8% annually in government bonds, that’s your baseline.

Risk-free rate: Treasury bonds are the starting point. Then, add a “risk premium” depending on how risky your project is.

Comparative analysis: In your industry, what discount rates do other investors use? This helps you stay aligned with common practice.

Experience and intuition: After several projects, you develop a sense of what’s a reasonable rate.

Cracks in the armor of NPV

NPV is a powerful tool, but it’s not perfect:

Despite these limitations, NPV remains widely used because it’s relatively easy to understand and apply, provides a concrete dollar or euro figure, and allows for coherent comparison of multiple investment options.

The Internal Rate of Return )IRR###: The percentage that says almost everything

IRR is the interest rate at which the NPV becomes exactly zero. In other words, it’s the “break-even” point of the investment. If the IRR is 15%, it means your money grows at that rate annually over the project’s life.

How is it used? You compare the IRR with a reference rate (such as the interest rate on government bonds or your opportunity cost). If the IRR exceeds that reference rate, the project is profitable. If it’s lower, it’s not.

( Why investors love IRR

It’s intuitive: a percentage is easier to understand than a dollar amount. If you’re offered two projects with IRRs of 12% and 8%, you instinctively know which is better )the first(. Also, IRR is especially useful for comparing projects of different sizes, where NPV can fall short.

The weaknesses of IRR you can’t ignore

IRR has its own problems that investors should be aware of:

When NPV and IRR contradict each other: Which to trust?

This is common in projects of different sizes or with unusual cash flow patterns. A project may have a higher NPV but a lower IRR than another.

What to do? Most financial experts recommend prioritizing NPV. Why? Because it measures the absolute value generated, which is what really matters to your wallet. IRR is useful for context and relative comparison but shouldn’t be the sole reason to choose a project.

When contradictions occur, review:

• The discount rates used
• The accuracy of your cash flow projections
• Whether there are non-conventional cash flows

Sometimes, adjusting the discount rate to better reflect the project’s risk resolves the contradictions.

Other tools to complete your analysis

Don’t rely solely on NPV and IRR. Other indicators complement the analysis:

• ROI )Return on Investment(: Measures profit as a percentage of the initial investment
• Payback Period: How long it takes to recover your initial money?
• Profitability Index )PI###: Relates positive flows to initial investment
• Weighted Average Cost of Capital (WACC): Helps you select the correct discount rate

Practical guide to choosing between investment projects

Here’s the process recommended by professionals:

1. Calculate the NPV of each project using a realistic discount rate
2. Calculate the IRR of each project as a reference point
3. Select the project with the highest NPV, provided the IRR exceeds your reference rate
4. If there’s a conflict between NPV and IRR, base your decision on NPV
5. Consider other factors: actual risk, available liquidity, personal objectives, portfolio diversification

Final points summarizing everything

NPV tells you how much real money you will generate. IRR tells you how fast your investment grows. One is about absolute amount; the other about relative speed. Both are valuable, but they are different lenses on the same picture.

Sophisticated investors use both tools together because they complement each other. NPV captures total value; IRR provides context on the efficiency of that value creation. However, in case of conflict, NPV is the final arbiter.

Remember that both NPV and IRR depend on future projections and subjective discount rates. There’s always uncertainty. That’s why, before investing real money, consider your personal circumstances, risk tolerance, investment horizon, and specific financial goals.

Frequently asked questions about NPV and IRR

Can NPV be negative even if IRR is positive?
Theoretically no, but they can seem contradictory if different discount rates are used. Review your assumptions.

Which should I use if I can only choose one?
Use NPV. It’s the most reliable metric for investment decisions.

Why is the discount rate so important?
Because a small change in the discount rate can dramatically alter NPV or IRR. That’s why you must choose it carefully.

How does inflation affect it?
The discount rate attempts to correct for inflation, but if actual inflation is higher than expected, your projections will be inaccurate.

Should I use both NPV and IRR for all investments?
They work best for projects with predictable cash flows over several years. For shorter or more volatile investments, consider other tools.