The Formula
The profitability index is calculated by dividing the present value of future cash flows by the initial cost (or initial investment) of the project. The initial costs include the cash flow required to get the team and project off the ground. The calculation of future cash flows does not include the initial investment amount. The present value of future cash flows is a method of discounting future cash to its current value, and requires the implementation of the time value of money calculation. This discounting occurs because the current value of $1 is not equivalent to the value of $1 received in the future. Money received closer to the present time is considered to have more value than money received further in the future. A profitability index of 1 indicates breaking even, which is an indifferent result for potential investors. If the result is less than 1.0, logic suggests that the investment should be avoided, as the project’s costs outweigh the potential profits. If the result is greater than 1.0, investors will likely go on to consider the other merits of the project. If the profitability index of a project is 1.2, for example, investors would expect a return of $1.20 for every $1.00 spent on funding the project.
Application
The profitability index is often used to rank a firm’s investments and/or projects alongside others. For the sake of maximizing limited financial resources and profits for shareholders, investors naturally want to spend money on projects with high short-term growth potential. When there are a multitude of investment projects available, would-be investors can use the profitability index (alongside other formulas) to rank the projects from high to low before deciding which is the best opportunity. Even when a project offers a high net present value, it may still be passed over based on the use of other financial calculations. It’s important to note that one problem with using the profitability index is that it does not allow a business owner to consider the full scope of the project. Using the net present value method of evaluating investment projects helps mitigate this problem, but raises other details worth considering. Certainly, the time a project requires to become profitable is a persistent concern for investors, and market factors can elongate the time table in unpredictable ways. Treat the profitability index as a helpful guideline, but always use it in tandem with the net present value method and other forms of multifaceted analysis.
