PROFITABILITY INDEX: HOW TO CALCULATE IT AND EXAMPLES - DUDAS - 2024

The profitability ratio is the net profit or loss that an investment has during a given cycle of time, expressed as a percentage of the initial cost of the investment. The investment profit is defined as the income obtained plus the profit received from the sale of said investment.

In economics, the return is the benefit on an investment. It covers any variation in the value of the investment, in addition to the cash flows received by the investor, such as dividend or interest payments.

Source: pixabay.com

It can be measured in absolute monetary terms or as a percentage of the amount invested. The latter is also called the return of the holding period. If there is a loss, rather than a profit, it will be described as a negative return, assuming the amount invested is not zero.

To compare returns all other things being equal over time periods with different durations, it is useful to be able to convert each return to an annualized return.

What is the profitability index?

The profitability ratio is the profit, or loss, compared to the initial cost of an investment. It is generally expressed as a percentage.

Taking into account the effect of time value of money and inflation, the real rate of return can also be defined as the net amount of cash flows received on an investment after being adjusted for inflation.

When this index is positive, it is considered a profit, and when it is negative, it reflects a loss on the investment.

It can be used in any investment vehicle, from stocks and artwork to real estate to bonds. It is always used when the asset is purchased at some point and a cash flow is generated at some point in the future.

Investments are evaluated based, in part, on previous performance ratios. These can be compared with assets of the same type to determine which investments are the most attractive.

How to get a good profitability ratio

How do you know if the return on an investment is good or not? What would be a good rate of return?

In general, investors who are willing to take higher risk are generally rewarded with higher rates of return.

Stocks are among the riskiest investments, because there is no guarantee that a company will remain viable. Even large corporations could fail overnight and leave investors with nothing.

One way to minimize risk is to invest in a variety of companies in different sectors and asset classes. That is, in stable value funds, bonds, real estate, and stocks, over a long period of time.

That may not lead to the desired 15% to 35% returns, but diversification can prevent a market crash that wipes out your lifetime savings.

Investors who have kept investing in stocks in the S&P 500 Index have gained about 7% on average over time, adjusted for inflation.

How to calculate it?

The equation shown below is used to calculate the profitability index:

Profitability Index = ((Final Investment Value-Initial Investment Value) / Initial Investment Value) x 100.

This simple value of the profitability index is sometimes also called return on investment or ROI.

The profitability index can be calculated for any investment, related to any asset class.

Practical case

One can take the example of buying a house as a basic example to conceive how this index is calculated.

Suppose a house is purchased for $ 250,000. For simplification purposes, 100% is paid in cash. Five years later, it is decided to sell the house; because maybe the family is growing and needs to move to a bigger place.

The home can be sold for $ 335,000, after deducting any real estate agent's fees and taxes.

The profitability index for the purchase and sale of said house will then be: ((335,000-250,000) / 250,000) x 100 = 34%.

However, what if the home sold for less than what was paid for it? Suppose, for example, for $ 187,500.

The same formula can be used to calculate the loss, which would be the negative profitability ratio, in trading: ((187,500-250,000) / 250,000) x 100 = -25%.

Examples

Example 1

Ramón is an investor and decides to buy 10 shares of Company XYZ at a unit price of $ 20. Ramón holds these shares of XYZ Company for two years.

In that term, Company XYZ paid $ 1 per share as annual dividends. After keeping them for two years, Ramón decides to sell his ten shares of Company XYZ at a price of $ 25.

Ramón would like to establish the profitability index during the 2 years in which he owned the shares.

Solution

To determine the profitability index, first the amount of dividends received during the 2-year period is calculated, being:

($ 1 annual dividend x 2 years) x 10 shares = $ 20 in dividends.

Next, the calculation is performed to find out at what price the shares were sold, as follows: $ 25 x 10 shares = $ 250, which is the profit from the sale of the shares.

Finally, it is checked how much it cost Ramón to buy the ten shares of Company XYZ: $ 20 x 10 shares = $ 200, which is the cost of buying the 10 shares.

Finally, all the amounts are linked in the profitability index equation: (($ 20 + $ 250 - $ 200) / $ 200) x 100 = 35%

Consequently, Ramón achieved a 35% return on his shares over the two-year period.

Example 2

John Doe opened a lemonade stand. He invested $ 500 in the company and selling lemonade makes about $ 10 a day, about $ 3,000 a year, taking a few days off.

In its simplest form, John Doe's one-year rate of return is simply earnings as a percentage of investment, or $ 3,000 / $ 500 = 600%.

There is a fundamental relationship to keep in mind when thinking about profitability ratios: the more risky the company, the higher the expected profitability ratio.

References

1. Will Kenton (2018). Rate of Return. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2019). Rate of return. Taken from: en.wikipedia.org.
3. CFI (2019). Rate of return. Taken from: corporatefinanceinstitute.com.
4. Michelle Rama-Poccia (2018). What Is Rate of Return and What Is a Good Rate of Return? The Street. Taken from: thestreet.com.
5. Study (2019). How to Calculate the Rate of Return: Definition, Formula & Example. Taken from: study.com.