Profitability index

What it means

The profitability index is the present value of an investment's future cash flows divided by its initial outlay. If a 100,000-euro project brings 130,000 euros in present value, the index is 1.3. A value above 1 means the investment creates value; below 1 it destroys value.

It is closely linked to net present value, NPV: the profitability index equals one plus NPV divided by the investment. While NPV shows the absolute value created in euros, the index shows how much value each euro invested brings.

The calculation requires a discount rate reflecting the project's required return and risk. The index is one of the tools of capital budgeting, alongside IRR and the payback period.

How it works in practice

The index helps rank projects when a company cannot fund them all, for example with a limited investment budget. Projects with the highest index deliver the most value per euro, and the company selects them until available funds run out.

All relevant cash flows must be included: the investment, operating savings or income, changes in working capital, taxes and the residual value at the end. Depreciation itself is not a cash flow, but it affects taxes, which are.

The index is complemented by the payback period, which shows how quickly the money comes back, and by qualitative factors such as strategic importance or risks. In public projects, a similar approach is used in cost-benefit analysis.

What to watch out for

The index favours small projects with high returns per euro, even though a larger project with a lower index may create more total value. Without a budget constraint, NPV is the more reliable basis for choosing between mutually exclusive projects.

The result is only as good as the assumptions. Optimistic sales estimates or too low a discount rate can turn an unattractive project into a seemingly excellent one, so it pays to run a sensitivity analysis and check under which assumptions the index falls below 1.