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Definitions: NPV, IRR, ROI and payback

Learn the definitions for commonly confused terms related to return on investment (ROI) in this expert Q/A.

Could you, please, define the following terms?

  • Net present value (NPV)
  • Internal rate of return (IRR)
  • Return on investment (ROI)
  • Payback

I went to Ventureline.com, where they have a very nice dictionary of accounting terms, and looked these up since they always give me trouble remembering which is which.

NET PRESENT VALUE (NPV) is a method used in evaluating investments, whereby the net present value of all cash outflows (such as the cost of the investment) and cash inflows (returns) is calculated using a given discount rate, usually required rate of return. An investment is acceptable if the NPV is positive. In capital budgeting, the discount rate used is called the hurdle rate and is usually equal to the incremental cost of capital.

INTERNAL RATE OF RETURN (IRR) is also called the dollar-weighted rate of return. IRR is calculated as the interest rate that makes the present value of the cash flows from all the sub-periods in an evaluation period plus the terminal market value of the portfolio equal to the initial market value of the portfolio.

RETURN ON INVESTMENT (ROI) is a profitability measure that evaluates the performance of a business. ROI can be calculated in various ways. The most common method is Net Income as a percentage of Net Book Value (total assets minus intangible assets and liabilities).

Other ways to measure payback include the following:

RETURN ON ASSETS (ROA) shows the after tax earnings of assets. Return on assets is an indicator of how profitable a company is. Use this ratio annually to compare a business' performance to the industry norms: The higher the ratio the greater the return on assets. However this has to be balanced against such factors as risk, sustainability and reinvestment in the business through development costs.

RETURN OF CAPITAL is the distribution of cash that resulted from tax savings on depreciation, sale of a capital asset or securities, or any other sources unrelated to retained earnings.

RETURN ON CAPITAL EMPLOYED (ROCE) is a measure of how effectively the company is using its capital. The formula to measures the return on all the assets the company is using: Profit before interest and tax (PBIT)/(total assets - current liabilities).

RETURN ON EQUITY (ROE) measures the overall efficiency of the firm in managing its total investments in assets and in generating a return to stockholders. It is the primary measure of how well management is running the company. ROE allows you to quickly gauge whether a company is a value creator or a cash consumer. By relating the earnings generated to the shareholders' equity, you can see how much cash is created from the existing assets. Clearly, all things being equal, the higher a company's ROE, the better the company.

RETURN ON INVESTED CAPITAL (ROIC) is a measure of how effectively a company uses the money (owned or borrowed) invested in its company operations. It is calculated by: net income after taxes/(total assets less excess cash minus non-interest-bearing liabilities).

 

This was first published in March 2004

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