The profitability index is a tool which investors can use to understand the degree of expected profits that may come from a specific investment. To calculate the profitability index, you will first need to know how much you intend to invest to get the returns you want for the future. Then you include the NPV (net present value), which is the current price of the future cash flow that is anticipated.
After you’ve calculated the NPV, you would divide the present value of the cash flows by the total initial investment to arrive at the figure. The final result would then let you know if the investment will achieve the gains you’re hoping to obtain or if a better investment opportunity might be needed in the future.
Here are some of the advantages and disadvantages of the profitability index to consider before using this tool in your own personal investments.
List of the Advantages of a Profitability Index
1. It provides you with information about how an investment changes the value of a firm.
When you’re calculated the profitability index, you’re getting to take a peek at what a potential investment may offer to the overall value of the business involved. It gives you an opportunity to see if your investment makes a real difference in their bottom line, which creates profit opportunities for you, or if the results would be negligible. With this information, you can determine if your value will improve the value of everyone involved or be absorbed into what everyone else is doing.
2. It will take into consideration all cash flows from a project.
Some investment tools will only use published cash flows or exclude certain cash flows that don’t reach the books to create investment results. The profitability index takes a different approach. You’re using all of the cash flows that are generated from the business, even the one which are not classified on the books as outgoing or incoming cash flows, to determine what your NPV will be. That means you have more valuable data to consider when deciding if an investment makes sense.
3. It will take the time value of money into consideration in the calculation.
Money will invariably have value throughout history. The difference is the value of that money. In 1934, you could purchase a lot more for $1 than what is available today. Even the value of money from 2010 is different than the value of 2018 money because of inflation. In 2010, if you were to purchase something for $1, then that same item would cost $1.16 today, according to a standard inflation calculator. Your profitability index will take these changes into account to ensure your information is as accurate as possible.
4. It considers the risks which are involved with future cash flows.
Cash flows are uncertain, even if there are incoming or outgoing cash flows which happen regularly. If this risk is not accounted for, then it becomes difficult to fully understand what may occur over the life of the investment. A better picture of the risks will also give you an idea of the profits that can be earned over time while understanding what the final costs may be at the end of the calculated period.
5. It will give you information about ranking projects while still rationing capital.
Investments happen all the time in the business world. The profitability index does more than calculate an equity investment for individuals. Companies can also use this tool to determine if certain projects are worth an investment in the future. These figures can let them know if one project will be more profitable than another, which allows them to choose the better option for long-term development and growth.
6. It is an investment tool that is easy to understand.
The formula used to create the profitability index is one that uses simple division only. As long as you know the present value of all cash flows and the initial investment, then you can determine the answer that this tool provides. Although more than just this tool should be used to make investment decisions, the answer will give you a base value of 1. If your calculation is less than 1, then the project has more risk associated with it. If the calculation is above 1, then there are fewer risks associated with the project.
List of the Disadvantages of a Profitability Index
1. The information generated is based on estimates instead of facts.
There is no getting around the fact that facts are not used to calculate the profitability index. You’re using a best-guess estimate as to what future cash flows will be, using current information. In the world of business, there are no guarantees. What may be a lucrative opportunity today could be a terrible investment idea tomorrow. If there are changes to the cash flows that are unanticipated, then the NPV will be incorrect and the profitability index will be useless to use.
2. It may not provide correct decision-making criteria for certain projects.
The NPV creates an investment figure that is based on short-term projects more than long-term results. If a company were to evaluate a project looking at the short-term profit potential, then it may undervalue what the long-term profitability of a project may be. The profitability index tends to score short-term gains better than long-term gains, which means some companies may choose the wrong project to complete what comparing their options.
3. The tool ignores what is called the “sunk cost.”
When a project is being started, capital budgeting classifies the costs that are incurred before the starting date as a “sunk cost.” If you have research and development costs for a project before you reach the groundbreaking stage, then the R&D would qualify. The profitability index does not include these incurred costs as part of the cash outflows which are calculated. Ignoring these costs could have big consequences for a corporation, including the denial of a financing plan, because only the information from the profitability index was used.
4. It can be difficult to estimate opportunity costs.
The cash inflows and outflows are not the only estimates which are used when calculating a profitability index figure. You’re also forced to estimate the opportunity cost, which is defined as a cost which occurs by not accepting alternatives which could have generated a positive cash inflow. Some agencies may not even attempt to calculate these costs. If the alternatives are difficult to estimate, the results from the profitability index may be distorted.
5. The profitability index often relies on optimism.
A profitability index is usually calculated by people or teams that are close to the projects or companies being examined. Investors often look at equity opportunities that they feel close to at first, for example, or an executive team may calculate the profitability index with optimistic figures because they have high hopes for a specific project. Before making a final decision, a review of all cashflow projections must occur because internal projects are often high, which creates an upward bias when trying to create your final estimates.
The profitability index is one of many tools that can be used to determine the full potential of an investment opportunity. It must be used carefully, however, because much of the information that is used to calculate results is based on estimates. Use this tool with other investment tools, while managing internal bias when it occurs, to achieve the best possible results.