When will I get my money back? This week Tim Bennett explains how payback can answer this simple, but vital, question.
Payback – a key term for investors in 2018
Many investors may have already decided on a New Year’s resolution. If not, here’s my suggestion for anyone unfamiliar with investing jargon – get to grips with payback.
Payback answers one of the most important questions that any investor, company or indeed consumer should ask – when will I get my money back? In a nutshell, the longer it takes, the greater the risk. This can be summed up as follows;
To show how the simplest version of the calculation works, here is an example;
You can see that it takes about 5 years and 10 months for the initial outlay to be recouped. This assumes, of course, that the projected cash inflows are both accurate and received on time. It also ignores an important concept in investing – the time value of money. We can tweak the example to take account of this as follows;
The effect of introducing a discount rate is to push back the payback date as each cash flow is reduced in what is called “present value” terms. Whilst discounted payback is a more accurate reflection of reality, it does introduce a new challenge when it comes to determining the discount rate.
Why payback is useful
Although a seemingly simple concept, payback is incredible useful;
It is all too easy to get wrapped up in the more complex investment calculations (such as ROI) and lose sight of the importance of cash flow returns and payback. That said, being a fairly simple calculation, even in its discounted form, it does have limitations;
Perhaps the most important of these criticisms is that payback offers no insight into the overall profitability of an investment opportunity. As such, the usual rule applies – don’t rely solely on one metric. Payback should be used alongside other measures of investment return and performance to complete the picture as to whether an investment stacks up, or not.