When you’re preparing financial projections to raise funds for your business, you need to assess whether your business is a good investment for investors. To do so, we look at the investment payback period.
Indeed, investment payback is a very common financial metric investors use worldwide to select which businesses and projects they should invest in. So if you’re looking to raise money from investors, put yourself in their shoes and use the same methodology to showcase how profitable your business opportunity is.
In this article we’ll look at what investment payback is, when we use it and how to calculate it. Let’s dive in!
What is investment payback?
Investment payback (also referred to as “payback period”) is the time it takes for an investment to generate enough income (or profits) to recoup the initial investment cost.
In other words, the investment payback is the time it takes for an investment to reach the breakeven point.
As such, investment payback is a measure of the efficiency of an investment: the shorter the payback period, the more profitable an investment is.
Investment payback formula
As an investor, to calculate investment payback you must divide the average annual cash flows you expect to earn from an investment over a period of time (for example 5 years). Then you simply divide this number by the original investment cost.
Investment payback = Average annual cash flows / Investment cost
Investment payback example
For example, let’s assume you have $100 to invest and 2 investment opportunities available to you which you must choose from:
| Option | A | B |
|---|---|---|
| Investment cost | $100 | $100 |
| Average annual profits | $40 | $50 |
| Payback period | 2.5 years | 2.0 years |
Option B would then be the logical option as the payback period is shorter (2 years). In other words, you would get your investment back quicker by investing in option B vs. option A.
What is a good payback period?
There is no good or bad payback period. It depends on the asset class (real estate, venture capital, debt investment, etc.).
Logically, the shorter the better.
However, it is important to consider other factors such as the potential for future profits and the level of risk associated with the investment, as well as the time value of money, which takes into account the impact of inflation on the value of money over time.
Payback period and investment risk
Let’s use the same example as before, let’s suppose we have the following 2 investment opportunities with the corresponding cash flows:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|---|
| Option A | -$100 | $40 | $40 | $40 | $40 |
| Option B | -$100 | $10 | $20 | $110 | $60 |
Option A still has average annual profits or $40 and option B $50. So from a payback perspective, option B is a better investment vs. option A.
Yet the difference here is the variance of the cash flows for option B which may suggest the expected cash flows are less predictable vs. option A and therefore more risky.
As with most financial projections, there’s a certain level of uncertainty. That’s where some investors may prefer to invest in lower-risk investment opportunities depending on their risk-reward investment preferences.
As such, whilst some investors would choose here option B as it has a lower payback period, some would instead choose option A as it’s less risky.
Payback period and time value of money
Another important concept when looking at investment payback is the time value of money.
The time value of money is a concept in finance that recognizes the fact that $1 available today is worth more than $1 in the future, due to its potential earning capacity. This is because money can be invested and earn a return over time, so the value of money increases as it earns interest or other investment returns.
Using the same example again, let’s assume the discount rate investors use to assess option A and B is 10%, we have the following discounted cash flows instead:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Payback | |
|---|---|---|---|---|---|---|
| Option A | -$100 | $36 | $33 | $30 | $27 | 3.1 years |
| Option B | -$100 | $9 | $17 | $83 | $41 | 2.7 years |
Here, the payback period increases (as the future cash flows are discounted) yet our conclusion is identical. Indeed, option A has a payback period of 3.1 years and option B of 2.7 years instead.
Now, assuming option B is indeed more risky vs. other option A, investors would instead require a higher return on investment. Assuming the required return on investment is 10% for option A and 15% for option B, we would obtain the same payback period.
This explains why some investors would rather opt for option A instead of option B as we just saw earlier.
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Payback | |
|---|---|---|---|---|---|---|
| Option A | -$100 | $36 | $33 | $30 | $27 | 3.1 years |
| Option B | -$100 | $9 | $15 | $72 | $34 | 3.1 years |
Payback period and return on investment (ROI)
As we just saw payback has its advantages as it’s very easy to calculate, yet it also comes with its share of drawbacks (risk, time value of money).
That’s why we typically use payback in conjunction with return on investment to form a better judgment on a given investment opportunity.
In order to calculate ROI, we discount future cash flows over a specific period (for example 5 years) which we sum up and divide against the original investment cost.
ROI = Sum of discounted cash flows / Investment cost
Using the same example again, here is what we would obtain for the next 5 years:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Payback | |
|---|---|---|---|---|---|---|
| Option A | -64% | -31% | -1% | 27% | 3.1 years | |
| Option B | -91% | -76% | -4% | 30% | 3.1 years |
Again here, payback is the same (3.1 years). In other words, with both investments investors get their money back within 3 years more or less.
Yet here the difference is the return on investment over time. Whilst both option are not profitable before year 4 (which makes sense given payback is 3.1 years), option B has a higher ROI in year 4 vs. option A. So all other things being equal, as an investor you would logically choose option B over A in this case.
