Also known as the benefit cost ratio, the present value index has to do with the relationship between the total expense involved with acquiring and owning an asset, and the net present value of that asset. The idea behind calculating the ratio is to determine if the investment is profitable or if the investor is currently experiencing a loss by continuing to hold that asset. Investors will often calculate the present value index as a means of either evaluating the prospects of acquiring a particular asset, or even in deciding whether to retain ownership of an asset that is already part of the financial portfolio.
Calculating the present value index (PVI) of an asset involves identifying the present value of all anticipated profits or cash flows from that asset, then dividing that figure by the purchase price plus any other costs associated with owning the asset. If the result is a figure that is more than a ratio of one, this means that based on the data used, the asset is likely to be profitable and worth securing. Should the ratio be less than one, that is an indicator that the asset is likely to cost more over time than any revenue it will generate, ultimately leading to a loss. With the latter situation, the investor would do well to avoid making the purchase and focus his or her attention on a different investment opportunity.
It is important to note that the value of the present value index is only as good as the data used to make the calculation. This means that if the data used to project future earnings from the asset are flawed in some manner, the resulting ratio will not be correct. As a result, the investor may think that the asset is likely to be quite profitable, when in fact the prospects are for a more modest return or possibly even a loss over a specified period of time.
Along with using the present value index to evaluate the potential of a given investment, businesses can also use this same approach to evaluate the prospects of a particular project. As with securing assets, it is important to make sure all the data considered as part of the calculation is accurate and complete. Failure to do so could mean that the project ultimately costs more than projected or the results of the project do not provide the anticipated revenue stream. In either scenario, the project could ultimately incur a loss rather than generating profits for the company.