Guides Finance

How Investment Returns Are Measured

ROI, annualised return (CAGR), IRR, NPV and payback period explained with one worked example, and why a plain average of yearly returns misleads.

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Investment performance can be described several ways, and each answers a different question. ROI gives the total gain relative to cost, CAGR turns it into a steady yearly rate, IRR handles uneven cash flows, NPV states value in today's money, and the payback period says how long it takes to recover the outlay.

One worked example

You invest 10,000 and receive 2,000, 3,000, 4,000 and 5,000 at the end of years 1 to 4, a total of 14,000 back.

Measure Result How
Total gain 4,000 14,000 − 10,000
ROI 40.0 % 4,000 ÷ 10,000
Simple average per year 10.0 % 40 % ÷ 4 years
CAGR (if it were a single lump sum growing to 14,000) 8.78 % (14,000 ÷ 10,000)^(1/4) − 1
IRR of the actual cash flows 12.83 % Rate at which NPV = 0
NPV at an 8 % discount rate 1,274.35 Each flow ÷ (1.08)^year, minus 10,000
Payback period 3.2 years Cumulative inflows reach 10,000 during year 4

The IRR is higher than the CAGR because money came back early: cash received in years 1 to 3 can be reinvested. The positive NPV at 8 % says the project beats an 8 % alternative.

Compute these with the ROI Calculator, IRR Calculator, Payback Period Calculator and Average Return Calculator.

Why the plain average misleads

If an investment rises 50% one year and falls 50% the next:

Result
Arithmetic average 0 %
Actual outcome 1.5 × 0.5 − 1 = -25 % over two years
Geometric average per year -13.4 %

Always use the compound (geometric) rate when comparing returns over several periods.

Common pitfalls

  • Ignoring time. ROI says nothing about how long the gain took.
  • Comparing IRRs of projects of very different size. Look at NPV too.
  • Forgetting fees, taxes and inflation. Returns that look healthy can shrink after all three. See Inflation.
  • Trusting payback alone. It ignores everything that happens after the break-even point and the time value of money.

For related ideas see How Compound Interest Works, and Return on investment (ROI), Internal rate of return (IRR) and CAGR for definitions.

Try these tools

ROI Calculator

Calculate the total return on investment (ROI) and annualized ROI from a known cost and final value -- no assumed rate of return required.

IRR Calculator

Calculate the internal rate of return (IRR) for an initial investment followed by a series of periodic cash flows.

Payback Period Calculator

Calculate how many years it takes to recover an initial investment from a series of periodic cash inflows.

Average Return Calculator

Calculate the arithmetic mean and the geometric mean (annualized/CAGR) return for a series of up to five periodic percentage returns.

See also

  • Guide How Compound Interest Works
    The compound interest formula with a worked $10,000 example, how compounding frequency matters, APR versus APY.
  • Glossary Return on investment (ROI)
    Return on investment (ROI) is the gain or loss on an investment as a percentage of what was invested.
  • Glossary Internal rate of return (IRR)
    The internal rate of return (IRR) is the yearly discount rate at which the present value of an investment's cash flows adds up to zero.
  • Glossary CAGR
    CAGR is the constant yearly growth rate that would take a value from its starting amount to its ending amount over a period.
  • Glossary Net present value (NPV)
    Net present value (NPV) is the sum of an investment's future cash flows, each discounted back to today's money, minus the initial cost.
  • Glossary Inflation
    Inflation is the general rise in prices over time, which reduces what each unit of money can buy.
  • Glossary Present value
    Present value is what a sum of money to be received in the future is worth today, after discounting it at a chosen rate of return.

Frequently Asked Questions

ROI for a quick total gain on a single outlay, CAGR to compare investments held for different lengths of time, IRR when cash flows arrive at different times, and payback period to judge how fast you get your money back. No single number tells the whole story.

Because returns compound. A gain of 50% followed by a loss of 50% averages 0%, yet leaves you with 25% less money. The geometric (compound) average is the honest figure.

Not necessarily. IRR ignores the size of the investment and assumes each cash flow can be reinvested at the IRR itself. Compare it with the project's NPV and the return you could earn elsewhere.

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