Finance
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# What is a Profitability Index?

Lee Flamand
Lee Flamand

A Profitability Index (PI), alternatively referred to as a profit investment ratio or a value investment ratio, is a method for discerning the relationship between the costs and benefits of investing in a possible project. It calculates the cost/benefit ratio of the present value (PV) of a project’s future cash flow over the price of the project’s initial investment. This formula is commonly written as PI = PV of future cash flows ÷ initial investment. The figure this formula yields helps investors decide on whether or not a project is financially attractive enough to pursue.

A profitability index of 1 designates the lowest measure by which it is logically acceptable to pursue a project. A value lower than 1 suggests that the project's possible value is lower than the initial investment. This means that the investor does not make a profit and should not invest in the project. A value exceeding 1 indicates financial gain, and as the number goes up, the investment becomes more attractive.

Aside from individual cases, many companies and investors use this index as a way of ranking a group of potential projects. Any project below one is excluded from the list altogether; those with a PI rating of one or higher are considered. The PI is thought to be useful for this task because it allows for the measurement and comparison of two or more separate projects, each of which require completely different investment amounts.

The number the profitability index yields projects the amount returned on each dollar invested. So, if the PI yields a 1.5, an investor can expect to get a return of \$1.50 US Dollar (USD) for each dollar invested. Alternatively, if the index yields a 0.9, an investor can expect to get \$0.90 USD back for each dollar spent, which results in negative returns.

The profitability index is related to another common financial formula called the net present value (NPV) indicator. These two formulas are often confused because they are both used for a similar purpose. However, while the PI measures the relative value of an investment, the net present value indicator measures the absolute value of an investment.

The profitability index is considered somewhat limited, in that it would instruct us to accept all investments above 1. However, it assumes that investors do not have to ration their capital and thus can invest as much as needs to be invested. However, if capital is scarce, an investor needs to consider the size of the investment itself, as investing large amounts of capital in just one project involves a large amount of risk.

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I imagine many venture capitalists out there might tell you that trying to project profitability index is a worthless idea, and they know a good idea when they see it. But that's also part of why I'm not a venture capitalist.

mitchell14

Profitability indexes are helpful, however it's important to remember that the value of possible investments If can never be entirely predicted. If you are considering investing in a new business, in a product idea, or even a stock that you know little about, asking a few different analysts for their thoughts on it's profitability index is likely to be a good idea. 