Metrics are simple and intuitive ways to judge investments without having to pour through pages and pages of data in spreadsheets. While not always the complete story, metrics give a numerical summary of a particular subject. Profitability Index is no different.
What is Profitability Index?
Profitability Index, or Profit Investment Ratio, helps investors understand the expected strength of a return in comparison to the initial investment. This calculation, however, is not as mundane as it sounds. Not only does it take into account the initial investment, but the return is discounted to reflect present day value, as money today is worth more than money in the future.
This ratio is powerful in that it is a ratio, meaning it can be applied to any currency! A simple definition from The Balance reads that Profitability Index “allows you to quantify the amount of value created per unit of investment.”
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How do I calculate Profitability Index?
The equation for Profitability Index is like all ratios, a division problem.
Profitability Index = Present Value of Future Cash Flows / Initial Investment
At this time, you are probably wondering, well how do I calculate the two parts of this division problem? And, more importantly, what does each part mean?
This is the more intuitive part of the equation. Basically, the money you put down to invest in something goes into this line.
Present Value of Future Cash Flows
Now, this is the equation within the equation.
To understand this term, I think it would be beneficial to break it down into parts.
“Future Cash Flows” means the money that you expect will be generated by an investment. Please note, this does not include the amount of the initial investment.
“Present Value” is the idea of discounting mentioned earlier. Again, this draws from the principle that money today is worth more than money in the future. Why is this? Money today can accrue interest.
To calculate all the cash flows for the future, you need to determine two things:
- Interest Rate: What interest rate would you expect if that money sat idly by?
- Years: How many years do you expect this investment to last?
With this information, you can calculate the present value of each future year’s cash flow!
Present Value for year number x = Cash Flow / (1 + interest rate)number of years
Adding all of these Present Values will give you the final part of the equation to calculate Profitability Index.
According to The Balance, the Profitability Index centers around 1.
“A profitability index of 1 indicates breakeven, which is seen as an indifferent result. If the result is less than 1.0, you do not invest in the project. If the result is greater than 1.0, you do invest in the project.”
Pretty simple, right? Below 1, hold off. Around 1, meh. Above 1, go for it. Keep in mind that the Profitability Indexes of multiple projects are compared to each other to see which is the best, not necessarily which ones are good bets.
Let’s try an example
It can be difficult to see equations within a vacuum, not having any real world applicability. To combat this, here is a common application of the Profitability Index.
The real estate industry utilizes the Profitability Index to see what kind of returns investing in a house would yield. The calculation is useful because, in real estate, the returns are relatively easy to predict. If the future returns are uncertain, then so is the Profitability Index.
Our friend, Kasey, is looking at a few houses to flip for profit. Essentially, she will buy a house, fix it up a bit, and then resell it.
So, using the Profitability Index, Kasey will decide which house is the best investment. We will assume all interest rates are 5%.
Her choices include:
Initial Investment: $300,000
Cash Flow in 3 years: $450,000
Initial Investment: $400,000
Cash Flow in 5 years: $450,000
Initial Investment: $200,000
Cash Flow in 2 years: $300,000
For House A, we have the top line of the division problem in the initial investment of $300,000. The bottom line can be found using the discounting equation Cash Flow / (1 + interest rate)number of years
$450,000 / (1 + 0.05)3 = $388,735
With these two numbers, we reach a Profitability Index of 1.29
For House B, the procedure is relatively the same, except the equation for cash flow is $450,000 / (1 + 0.05)5 = $352,664
House B has a Profitability Index of 0.88
The last option, House C, has a present value cash flow of $300,000 / (1 + 0.05)2 = $272,108
The Profitability Index ends up at 1.36
From this example, we can see how some investments are obviously not good (looking at you, House B). However, based on the calculation we should conclude that House C is the best investment choice. Why is that?
House A has a larger cash flow compared to the initial investment. Shouldn’t that be the right choice?
House C has a two year turn around, meaning that discounting is less of a factor. House A and C are both good choices according to the Profitability Index, but House C may be the best.
However, this calculation isn’t just for real estate and houses. Imagine projects for companies that include investing in research and development, expanding markets, or internal uses like new software.
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Net Present Value
Profitability Index is a great tool to judge investments, however it is not the only metric. Net Present Value is also widely used to take into account present value of future cash flow. You can read more about it here.
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