Calculating a Profitability Index
This calculator can be used to determine the profitability index of an investment along with the present value of cash flows and net present value of money. The calculator needs a total of five inputs, including:
- The initial investment being made, typically associated with the purchase of an asset by an investor
- The cash flow generated per time period, which can be any fixed span of time such as a year or month
- The number of time periods over which the cash flow is generated
- The opportunity cost per time period. If the time period selected is on year, then this would be the annual opportunity cost
- The final value of the investment, if any (this value can be zero)
The calculator then provides the user with three outputs:
- The present value of all cash flows, which discounts the cash generated by the opportunity cost per period
- The net present value of money, which subtracts the initial investment from the present value of all cash flows
- The profitability index for this investment, which takes the present value of all cash flows and divides it by the initial investment
Profitability index formula
Also known as the benefit to cost ratio, the profitability index of an investment is a simple measure of the returns generated following the purchase of an asset. When an investment’s profitability index is less than 1.0, the benefits derived from the investment (cash flowing back to the investor) will be less than the cash flowing from the investor (their purchase of the asset). The formula for profitability index is as follows:
Profitability Index = Present Value of Cash Flows / Investment
Pros of calculating benefit to cost ratios
One of the strengths of this metric is that it considers the time value of money, which means the cash flows are discounted by the investor’s opportunity cost. Because of this approach, the profitability index will always supply the same guidance as the net present value (NPV) of cash flows method. For example, if the NPV of cash flows is a positive value, then profitability index will have a value greater than one. In the same manner, when the NPV of cash flows is negative, profitability index will be less than one.
Another strength of profitability index is its ability to rank investments. Since higher values indicate higher levels of cash flow relative to the investment, this metric allows us to stack, or prioritize, investments based on their index value.
Cons of using profitability index to measure the value of an investment
There are two shortcomings of profitability index. The first has to do with timing. The ratio does not tell the investor when the present value of cash flow is achieved. The second has to do with the size of the cash flows; especially when the metric is used to rank investment potential. For example, an investment of 1.0 that has a present value of cash flows of 3.0 will have a profitability index of 3.0. While an investment of 100,000 that has a present value of cash flows of 290,000 will have a profitability index of 2.9.
For these reasons, alternative means of evaluating an investment, such as the NPV of cash flows, payback, and internal rate of return (IRR) are often used alongside of profitability index.