What is the Profitability Index?
The Profitability Index (PI) is the ratio between the present value of cash inflows and the present value of cash outflows.
- What is the definition of the profitability index?
- Which formula is used to calculate the profitability index?
- What is the profitability index rule for ranking projects?
- How is the profitability index different from the net present value (NPV)?
Table of Contents
Profitability Index Formula
The profitability index measures the monetary benefits (i.e. cash inflows) received for each dollar invested (i.e. cash outflow), with the cash flows discounted back to the present date.
More specifically, the profitability index ratio compares the present value (PV) of future cash flows received from a project to the initial cash outflow (investment) to fund the project.
Profitability Index = Present Value of Future Cash Flows / Initial Investment
Another variation of the profitability index formula adds the initial investment to the net present value (NPV), which is then divided by the initial investment.
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment
Rules for Interpreting the Profitability Index
The primary use-case for the profitability index is for ranking projects and capital investments.
The higher the profitability index, the more attractive the proposed project is and the more likely it will be pursued.
For some general guidelines on interpreting the profitability index:
- Profitability Index =1: Neutral/Acceptable
- Profitability Index >1: Approve Project
- Profitability Index <1: Reject Project
Profitability Index vs Net Present Value (NPV)
- If the profitability index is >1, then NPV will be positive.
- If the profitability index is <1, then NPV will be negative.
The major distinction between the two is that the profitability index depicts a “relative” measure of value whereas the net present value (NPV) represents an “absolute” measure of value.
With that said, for purposes of presenting a project or capital investment’s benefits on a per-dollar basis of the initial investment, the profitability index is more practical since it is standardized.
The profitability index can thereby be used for comparisons among different projects. By contrast, comparisons of NPV between projects are not always functional (i.e. non-standardized metric).
Profitability Index Excel Template
Now that we’ve discussed the profitability index formula and the rules for interpreting the ratio, we can complete a modeling exercise example in Excel. To access the file, fill out the form below:
Profitability Index Example Calculation
In our illustrative example, we’ll calculate the net present value (NPV) and profitability index (PI) of a proposed five-year project.
The following project assumptions will be used for our model.
- Discount Rate: 10%
- Project CF Growth Rate: 25%
- Initial Investment: –$10,000,000
- Project Cash Flows (Year 1): $2,000,000
The cost of funding the project is $10 million, and the amount of cash flows generated in Year 1 is $2 million, which will grow by a growth rate of 25% each year.
We can now calculate the net present value (NPV) of the project using the NPV function in Excel:
- NPV: “=NPV (10% Discount Rate, Range of Net Cash Inflows/Outflows)”
- NPV = $1,756,382
Next, we can calculate the profitability index given the NPV from the prior step.
The formula will consist of two parts:
- In the numerator, we’ll take the NPV and add back the initial investment.
- In the denominator, we’ll link to the initial investment cell with a negative sign in front (so both the numerator and denominator are positive figures).
Therefore, the profitability index formula divides the present value (PV) of the project’s future cash flows by the initial investment.
- Profitability Index = ($1,756,382 + $10,000,000) / ($10,000,000)
- Profitability Index = 1.2
In conclusion, the profitability index of our five-year project is 1.2, so the project seems likely to be accepted unless there are other projects with higher NPVs and profitability indices that are also under consideration.