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Profitability Index - Measure Investment Return
Profitability index is an investment
return measurement much like
net present value (NPV), with one notable difference.
NPV finds the dollar amount difference between
the sum of present values (PV) of all future cash flows
and the amount of initial investment.
Profitability index finds the ratio.
For example, let's say the
present worth of all future cash flows exactly equals your
initial investment. The NPV would
be zero (because there is no dollar amount difference)
whereas the profitability index would be 1.0 (because there
is no proportionate difference).
How to Calculate
Profitability Index = Present Value of all Future Cash Flows / Initial Cash Investment
Profitability Index vs Net Present Value
The advantage of using profitability index to measure
investment opportunities is that it allows you
to compare two real estate investment opportunities
that require different initial investments. Primarily
because profitability index is not sensitive to the amount
of the investment.
As a ratio, profitability index allows you to measure
the proportion of dollars returned to dollars invested, and therefore
allows you to easily compare PV and initial investment
on any number of investment opportunities.
How to Apply
PROPERTY A. Requires a cash investment of $150,000 and you estimate the PV of all its future cash flows at $160,000. Calculate profitability index by dividing the PV of future cash flows ($160,000) by your initial cash investment ($150,000). The index is 1.070.
PROPERTY B. Requires a cash investment of $90,000 and you estimate the PV of all its future cash flows at $99,000. Calculate profitability index by dividing the PV of future cash flows ($99,000) by your initial cash investment ($90,000). The index is 1.10.
Okay, which is the better deal?
Remember profitability index measures the ratio between cash flow to investment. Therefore, the higher the ratio the more cash flow to investment. So in this case the profitability index reveals that Property B is more profitable than Property A.
Here's a quick way to see whether or not you meet you meet your investment goal with profitability index.
A profitability index of 1.0 means you have exactly achieved your desired rate of return (i.e., the price you need to pay for the property based upon its future cash flows discounted at your rate of return is exactly right). An index greater than 1.0 means that you've exceeded your goal. An index less than 1.0 means that you failed to achieve your goal.
Simply put. To meet your investment goal, always be sure the profitability index is 1.0 or better.
ProAPOD® Real Estate Investment Software computes profitability index automatically as you enter the property and mortgage data. Profitability index is recalculated in real time each time you make changes to the data so it is always accurate. Reports such as the proforma income statement and assumptions include profitability index.
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