Profitability index: concept, formula

The profitability index shows how much a particular project will be profitable (relative), or how much money will be received in the course of this project. Only one unit of investment is considered.

Investments and profitability index

Before investing your money in a particular project, you need to try to determine which of the options will bring a big profit and how much good benefits you get with it. It is to find out this information, and there is a so-called index of profitability of investments. This indicator is also called the profitability index, or PI.

What you need to know about the index of profitability in the field of investment

With its help, you can easily calculate what the relationship between current income and current costs exists. It also takes into account the money that was invested in the project. In addition, the calculation is both real (in this case, those funds that have been received over the past period of time are calculated) and prognostic (when those incomes and expenditures that will still take place are taken into account).

If after calculations it turned out that PI is less than 1, then you can say that you received a net profit from investing in the project , which is less than the funds that were invested in it. This gives the right to assert that such an investment of money was unprofitable.

If the index of profitability of the investment is equal to 1, then the project can be either profitable or not. But PI, which is more than one, means that you have invested your money wisely and will receive a fairly large income. It should be remembered that the greater the value obtained, the more stable and reliable the project is. Also remember that when calculating long-term projects it often happens that the initial profit may not be more capital, so consider the time period.

The advantages and disadvantages of the index

The profitability index has its pros and cons. Among the advantages of this method, the most important is that it allows you to ideally distribute money in time. In addition, with its help you can determine what effects this or that project has had for its entire existence, as well as compare different projects in scale.

But he also has his own shortcomings. For example, the profitability index does not allow to rank projects without any problems, which have different duration. But, despite all the drawbacks, it is with the help of PI that you can easily assess the effectiveness of a fairly long-term investment and get an opportunity to calculate the profit.

The formula for profitability index

If we talk about how to correctly calculate PI, then here you will need a special formula, which looks like this:

PI = PV _in / PV _out

Or so

PI = 1 + NPV / PV _out

In these formulas, PV _in (NPV) means the net present value of the project, and PV _out is the capital investment.

The profitability index, the formula of which was described above, does not mean that you will certainly get the absolute size of the net cash flow, because it only indicates the relationship to investment costs.

If you are an investor and want to determine how successful a particular project is, then you need to know that the greater the investment costs, the greater will be the amount of net cash flow that you plan to receive. Also, the amount will be affected by the so-called amount of investment costs for different time periods. Has an important influence on the amount of money flow and when the operational phase began. The discount rate has a significant impact on the cost of the main project indicators in the investment area.