Profitability index is a measure that is used to calculate the cost-benefit relationship in an investment. It is one of the lesser know, but highly useful of the indexes that an investor can consider before making a large investment in real estate. Buying rental, or commercial property is usually done with returns in mind, and every investment has a certain level of risk that cannot be avoided. The inherent risk that is present in real estate is relatively less, but cannot be completely removed. Knowing how much risk is associated with a particular property can help you decide whether you should put your money in it.
Measuring profitability index
To measure profitability index there are three main factors that have to be considered; time, future cash flows and the initial cash investment. Through the application of these values, two measures can be derived – profitability index and the net present value. Profitability index is expressed as a ratio.
The formula: Profitability Index (PI) = Present value of future cash flows ⁄ Initial Investment
The least acceptable value here will be 1. Any value that is less than 1 will be considered unattractive and indicates that the present value is a lot less than the money invested. The higher the value, the more attractive the investment is, from a financial perspective.
Profitability index is a good way to measure the profitability of an investment, but, like all measures that attempt to measure future values, it is not final and binding. The ratio really comes to play when you want to compare projects. If you are looking at, for example, five real estate investment alternatives in different localities, you can make an informed decision based on the PI ratios.