Businesses need to make investments to grow — that’s a given. But how do you know which investments are likely to be worthwhile? There are a variety of ways to calculate a return on investment (ROI) — net present value, internal rate of return, breakeven — but the simplest is payback period.
What is payback period?
Payback is by far the most common ROI method used to express the return you’re getting on an investment. Chances are you’ve heard people ask, “How long until we make our money back?” And that’s exactly what the method shows you, says Knight: “The time it takes for the cash flow from the project to return the original investment.”
The shorter the payback period, the better. And it “obviously has to be shorter than the life of the project — otherwise there’s no reason to make the investment.” If there’s a long payback period, you’re probably not looking at a worthwhile investment.
The appeal of this method is that it’s easy to understand and relatively simple to calculate.
How do you calculate it?
Here’s what you do: Take the initial investment and divide it by how much cash you expect the investment to bring in each year.
Knight provides an example. Imagine that your company wants to buy a $3,000 computer that will help one of your employees deliver a service to your customers in less time. The computer is expected to last three years. At the end of each of the three years, the cash flow from the equipment is estimated at $1,300 — that’s the amount of extra money your company will make because it’s now providing this service to more customers.
To calculate the payback period, you’d take the initial $3,000 investment and divide by the cash flow per year:
Since the machine will last three years, in this case the payback period is less than the life of the project. What you don’t know is how much of a total return it will give you over those three years.
This is the major limitation of the payback method. As Knight says, “It doesn’t tell you much. After all, you probably don’t just want to break even on your investment. You want to make money.” This can lead to some deceiving calculations. Say, for example, the cash flow for the project was actually $3,000/year in Year 1 and nothing thereafter. According to the payback calculation, you’d have a payback period of one year, which would seem great: You get all your money back in one year. But without returns in future years you’re not actually making anything on your investment.
Further Reading – A Refresher on Net Present Value
How do companies use the payback method?
It’s most commonly used as a “reality check” before moving on to other ROI calculations. “The best use of payback, in my opinion,” says Knight, “is to quickly check on the numbers before deciding whether to investigate the investment further.”
Payback is often used to talk about government projects or relatively risky projects that are capital intensive. “Industrial and manufacturing companies tend to like payback,” says Knight. Companies that are cash strapped and don’t have a lot of capital to spend may also focus on payback period since they are going to need the money soon.
What mistakes do people make when using the payback method?
One of the fundamental flaws in the method is you’re not taking into account the time value of money, translating future cash flows into today’s dollars. It’s like comparing “cantaloupes to cabbages, because dollars today have a different value than dollars down the road,” says Knight. The longer the projects go, the less likely they are to be accurate.
“Payback tells you when you will get your initial investment back, but it doesn’t take into account the fact that you don’t have your money for all that time,” he says. For that reason, net present value is often the preferred method.
Another flaw is that payback tells you nothing about the rate of return, which is a problem if your company requires proposed investments to pass a certain hurdle rate.
Knight points out that some people will use “discounted payback,” a modified method that takes into account the discount rate. This is a much less straightforward calculation (though there are online tools, like this one, that do the math for you), but it is “far superior,” says Knight, especially if you’re only going to use the payback method. However, he warns, payback is really a “rough rule of thumb, not strong financial analysis.” After you’ve calculated it, and if your investment looks promising, it’s time to do a more rigorous analysis with one of the other ROI methods — breakeven, internal rate of return, or net present value.