Profitability Index

Profitability Index (PI) shows the relationship between company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability and it is calculated by one plus dividing the present value of cash flows by initial investment and it is also known as profit investment ratio as it analyses the profit of the project.

Profitability Index is a great metric to use when you need to decide whether you need to invest in something or not. If you have a company and you are on a tight budget, this metric helps you decide whether you should consider investing in a new project or not.

Profitability Index, as the name suggests, indicates how much profit a business can expect from investing in a project. It lets an entity establish a connection between what it spends and what it receives in the form of benefits. A higher PI is always considered better, thereby reflecting the profitability associated with the proposed projects.

The best thing about this index is that it allows businesses to compare between different projects whenever they require choosing one out of the other. The projects having more chances of generating profits is the project that the firms are likely to choose.

Firms follow the profitability index rule to obtain ratios that depict returns with respect to each investment dollars. Hence, it enables companies to choose projects that are best value for money.

When applying the PI technique to check on the profits expected from a project, it is recommended to not consider the size of the project. It is because there are instances where there re larger cash flows, but then the PI is limited due to the restricted profit margins. Hence, it is important to be wise when implementing this technique for accurate results.

When it comes to the profitability index equation to compute the value, there are different formulas that can be applied based on the information available. The two most widely used formulas are mentioned below:

Formula #1

The formula below looks very simple. All one needs to do is to find out the present value of future cash flows and then divide it by the initial investment of the project.

Profitability Index = Present Value of Future Cash Flows / Initial Investment Required

However, there is another way through which we can express PI, and that is through net present value. NPV method is a good measure as well to consider whether any investment is profitable or not. But in this case, the idea is to find a ratio, not the amount.

Formula #2

Let’s have a look at the PI expressed through Net Present Value –

Profitability Index = 1 + (Net Present Value / Initial Investment Required)

If we compare both of these formulas, they both will give the same result. But they are just different ways to look at the PI.

The value of the profitability index varies widely. Hence, it is important for analysts to interpret the values properly. Let us see what the values obtained from the calculation signify:

• If the index is more than 1, then the investment is worthy because then you may earn back more than you invest in. So if you find any investment whose PI is more than 1, go ahead and invest in it.
• If the index is less than 1, then it’s better to step back and look for other opportunities. Because when PI is less than 1, that means you would not get back the money you would invest. Why bother to invest at all?
• If the index is equal to 1, then it’s an indifferent or neutral project. You shouldn’t invest in the project until and unless you consider it better than other projects available during the period. If you find that the PI of all other projects to be negative, then consider investing in this project.

Let us consider the following instances to understand the profitability index definition better and also check how it is calculated:

Example # 1

N Enterprise has decided to invest in a project for which the initial investment would be $100 million. As they are considering whether it’s a good deal to invest in, they have found out that the present value of the future cash flow of this project is 130 million. Is it a good project to invest in in the first place? Calculate Profitability Index to prove that.

• PI = Present Value of Future Cash Flow / Initial Investment Required
• PI = US $130 million / US $100 million
• PI = 1.3

We will use another method to calculate the Profitability Index.

• PI Formula = 1 + (Net Present Value / Initial Investment Required)
• PI = 1 +
• PI = 1 +
• PI = 1 +
• PI = 1 + 0.3
• PI = 1.3

So, in both ways, the PI is 1.3. That means it’s a great venture to invest in. But the company also needs to consider other projects where the PI may be more than 1.3. In that case, the company should invest in a project that has more PI than this particular project.

Example # 2

Let’s say that ABC Company invests in a new project. Their initial investment is the US $10000. And here’s the cash inflow for the next 5 years –

• We need to calculate the Profitability Index and find out whether this project is worthy of their investment or not.
• So, we can find out the present value of future cash flows in two ways. Firstly, we can compute by adding up all the present values of future cash flows, and secondly, the relatively easier way is to find out the discounted cash flow each year.

So, we will take the second approach and add another column to the above statement, and that would be of discounted cash flows –

Now, you may wonder how we got these figures under the head discounted cash flows. We simply took separate present values of future cash flows. For example, in the first year, the future cash flow is $2000, the cost of capital is 10%, and the number of the year is 1. So the calculation would be like this –

• PV = FV / (1+i) ^1
• PV = 4000 / (1+0.1) ^1
• PV = 4000 / 1.1
• PV = 3636.36

We found out all of the above-discounted cash flows by using the same method. Only the cost of capital changed due to the increase in the number of years.

Now, we would do the profitability index calculations.

Now putting the values in the PI formula, we get –

PI Formula = PV of Future Cash Flows / Initial Investment Required

We will use the NPV method as well to illustrate the same so that we can understand whether we have come to the right conclusion or not, and we will also get to know how to calculate NPV.

To calculate NPV all, we need to do is to add up all discounted cash flows and then deduct the initial investment required.

So the NPV in this case would be = (US $6277.63 – US $5000) = US $1277.63.

By using the NPV method, we would now calculate profitability index (PI) –

• PI Formula = 1 + NPV / Initial Investment Required
• PI = 1 + 1277.63 / 5000
• PI = 1 + 0.26
• PI = 1.26

From the above computation, we can come to the conclusion that ABC Company should invest in the project as PI is more than 1.

Profitability index helps businesses assess their ability to make money and this is what makes it one of the most important metrics for estimating profits over a period efficiently. However, even if the PI is widely used for doing cost-benefit analyses, it is not free of demerits. As every good side has its limitations, PI also has a couple of limitations.

Let us have a look at the set of benefits and limitations associated with the concept:

Benefits

• As it allows businesses to assess each project against the profit they expect to generate, the firms can choose the most suitable projects for profit-making.
• The index also allows investors to examine if their investment decisions were good or they went wrong in making proper choices.
• It also helps in making a comparative study of the performances of different businesses. When a company’s performance is good, it indicates better management protocol and willing customers who pay for the products.

Limitations

• The first is the estimation of future cash flows. As forecasts are not always accurate, there are always chances that the expected future cash flows can be drastically different in the forecasting than in actuality.
• The PI of two projects can be similar even if the initial investment and the return are completely different. So, in that case, the best method to judge whether to invest in a project or not is the Net Present Value Method (NPV).

PI and Net Present Value (NPV) are two financial tools that are widely used as a profit estimation metric for businesses. PI and NPV are said to be directly proportional where positive NPV leads to PI that is greater than, while a negative NPV means a PI lower than 1.

In addition, these two concepts differ in various aspects, which include the following:

• While NPV indicates the size of the cash flow that a business generates, PI provides for the percentage of profit expected from a project.
• PI allows businesses to compare two elements or features or properties irrespective of the investments made in each, while NPV helps obtain the results, depicting what investment would reap what profits.
• PI is the ratio that lets individuals and entities assess percentage of dollars to be received on percentage of investments. On the contrary, NPV helps calculate the absolute cash flow expected in dollars.

This has been a guide to what is Profitability Index. Here, we explain its formula, advantages and disadvantages, examples, interpretation, vs NPV. You can learn more from the following articles on Corporate Finance -

• INDEX Formula
• Profitability Index Formula
• Break-Even Point
• MIRR in Excel