It closely follows net present value (NPV) in the sense that both weigh the present value (PV) against the initial investment made to purchase the property. But the index should certainly not be regarded as simply another way of expressing the same result as does net present value.
Allow me to explain.
NPV takes the sum of present values of all future cash flows and subtracts the amount of initial investment. The result is a dollar amount. If the difference is either a zero or a positive dollar amount, then the real estate investor can be assured that the rate of return he or she desires (as indicated by the discount rate) has been equaled or exceeded.
Whereas, with profitability index, instead of calculating the dollar amount difference between present value and initial investment, it calculates the proportion of dollars returned to dollars invested as a ratio. In this case, an index equal to, or greater than, 1.0 means the present worth of future cash flows equal or exceed the investor’s cash investment.
Profitability Index = Present Value of all Future Cash Flows / Initial Cash Investment
The primary advantage profitability index offers comes into play when the real estate investor wants to compare two investment opportunities that require different initial investments. Because the index is a ratio that is not sensitive to the amount of initial cash investment (unlike NPV). It measures the proportion only, regardless of the amount.
To illustrate how important it is for investors to calculate the index in addition to NPV, we’ll consider a very simple example in which the investor is trying to determine which of two investment opportunities offer the better rate of return. We’ll list the assumptions for both properties then calculate NPV and index for both.
- Property A Cash investment of $150,000 with a PV of all future cash flows at $160,000
- Property B Cash investment of $90,000 with a PV of all future cash flows at $99,000
In this case, the net present value would calculate the dollar amount difference between initial investment and PV of cash flows and result in the following:
- Property A $10,000 (160,000 – 150,000)
- Property B $9,000 (99,000 – 90,000)
At first glance the NPV makes Property A seem to appear more profitable than Property B because the difference in dollar amounts is higher. But look what happens when the index is calculated for both properties.
- Property A 1.07 (160,000 / 150,000)
- Property B 1.10 (99,000 / 90,000)
The profitability index reveals that Property B is actually more profitable than Property A because the proportion of dollars returned to dollars invested is higher. Again, a very simplified example. But you get the idea.
- Exactly 1.0 You have exactly achieved your desired rate of return
- Greater than 1.0 You exceeded your desired rate of return
- Less than 1.0 You failed to achieve your desired rate of return
So You Know