The primary goal of investing is to earn the potential for returns. There are a variety of ways to evaluate how well your investments perform. In this article , we will examine three metrics that are commonly used — the Return On Investment (ROI) as well as the Internal Rate of Return (IRR) and Net Present Value (NPV). We will also examine the ROI with IRR and NPV and examine the differences and similarities between the three.

Let’s start by understanding each one of them in isolation:

Return on Investment (ROI)

ROI is likely to be among the most frequently used measures of investment. If you are investing, some of the most frequently asked questions you are trying to answer are:

● Are the expected returns worth the risk or cost that are associated with investing?

● Does the investment make a profit?

● What is the amount of money I will get with my money?

ROI is a proportion or percentage that represents the percentage of return compared to cost of investment. Calculate Return on Investment by dividing the investment’s return by the cost of investment. Let’s look at an illustration

John invests 100,000 dollars over five years. He also incurs additional expenses of 25,000. After 5 years John is credited with an amount of 150,000 credit to his account. In this scenario ROI (ROI) will be determined in the following manner:

Total costs = 100,000 x 100,000–25,000 = 125,000

Total gains equal to 150,000

ROI = ((Gains — Investment Costs) / Investment Costs) x 100

= ((150,000–125,000) / 125,000 )x 100

= (25,000 / 125,000 ) X100

= 20%

Be aware that it is just a simple method to describe the ROI. Prior to calculating the ratio, it is crucial to take into consideration all gains and expenses that pertain to the investment on its own. Because the ROI is calculated in percentage terms and is possible to evaluate it against other investments in order to choose the best investment options.

ROI is easy to calculate, but it has some limitations. It is for instance, it does not provide a measure of the returns over a long time. As an example, let’s say John had two investments: “Investment A” that yielded him 20%, and “Investment B” which yielded him 30 percent. It is likely that Investment B was a better performance investment. But, when you consider that Investment A produced the returns over a two-year period, and Investment B returned over five years, it is simple to determine the fact that Investment A proved to be a superior investment option than Investment B.

Net Present Value (NPV)

Net Present Value is typically an instrument used in capital budgeting in order to evaluate the feasibility of a plan. It is a method of comparing the value of cash flows with the current values of the cash flows. Positive NPV means that the project will result in value creating, while a negative one signifies a net loss.

To calculate the NPV, you have to be aware of the total cost of investment (C0) as well as the total cash flows during the duration of the project (Ct) as well as the discount cost (r) (this can be typically what is known as the price of capital) as well as the time frame that the plan will last (t).

The formula is:

Let’s examine an example in order to comprehend this:

Let’s think about a different scenario. John plans to invest in a venture that will cost the investor $10,000. John hopes to earn an income of $3,000 per year for the next five years. John determines that the proper discount rate is 10 percent. When applying the above formula to this scenario, the NPV is $1,247.60 This indicates that this would be a good purchase for John.

While NPV can be a helpful method to assess the investment potential, it involves a lot of estimations and assumptions that can lead to possible errors or misrepresentation analysis. It is not possible to calculate the cost and return with absolute certainty. It is possible to use NPV together with other indicators to make the investment decision.

Internal Rate of Return (IRR)

In other words, the Internal Rate of Reward (IRR) refers to the percent return calculated for every period that is invested. It’s basically discounting that makes the NPV zero. IRR uses the same formula as NPV however instead of computing the NPV, it calculates the discount rate, resulting in zero NPV.

IRR is a valuable instrument to aid in making decisions about investment. If the IRR exceeds the cost of capital, it’s an investment that is profitable. When the IRR is lower than cost of capital then it is an investment that will lose money. It also allows you to compare various options. If you compare two alternatives to invest in the one with the highest return is more appealing.

Let’s look at this from an illustration. Let’s say John has put his savings in a fixed-deposit term, providing the investor with a return of 4.4%. If he has another investment choice offering an annual return of 9 percent. John could decide that the investment will yield greater yields for him. Of course, he has to decide if the 9% return is justified considering the risk involved in investing compared to a fixed deposit. As with many other measures, IRR does not come without problems. It can be difficult to assess alternatives of different lengths by using IRR. It is recommended to utilize it along with other measures, like the NPV.

Summing up

If you’re investing in Real Estate, it is essential to know the various methods to determine the success of your investments. These indicators can help you evaluate the performance of your investment and also compare the various investment alternatives. Of course, these metrics for return must always be evaluated to the risk involved with the investment to determine if they are worth the risk.