How to calculate the payback period

There are several ways of determining whether an investment will yield enough returns. One of the methods is to calculate the payback period. The payback period equation can help both businesses and individuals work out when an investment will pay for itself.

On this page, you’ll find out how to calculate the payback period and what the result means, so you can quickly and easily evaluate whether an investment is worth pursuing.

The payback period refers to the time needed to recoup the initial cash investment in a project or asset. It signifies the time it will take for an investor to get their entire initial investment back, as measured in after-tax cash flows. This is sometimes called the time it takes to reach “break-even point”, and is usually calculated in years.

The payback period formula is one of the methods used in capital budgeting, which is where an investor considers potential long-term investments by working out which one will give the best return and ultimately where to put their capital. So, the payback period is part of a bigger strategy that helps businesses plan their finances.

The payback period method is commonly used by investors and financial professionals to calculate investment returns, but companies and individuals may also use it to work out whether a certain project is cost-effective.

Calculating the payback period is fairly straightforward. You take the initial investment and divide it by the annual cash flow generated by the project. The payback period is typically expressed in years. So, this calculation gives you the number of years it will take to recover the initial investment.

If the cash flows are consistent each year, you simply divide the initial investment by the net cash flow per period to find the payback period. However, if the cash flows vary, you add up the years before full recovery with the unrecovered cost at the start of the year, then divide that sum by the cash flow during the year.

There are various online calculators available to help you calculate the payback period. Alternatively, you can easily work it out using a spreadsheet such as Excel.

A good payback period is typically the shortest one an investor can achieve. Some think a period of 12 months or less is a reasonable timeframe. However, what’s considered a “good” payback period can vary widely depending on factors like the particular industry, company size, and annual contract value.

An investor’s ultimate aim is to recover their initial investment or project cost as quickly as they can. This is because a shorter payback period means they have more flexibility to use those funds for other investments later on.

The formula for calculating the payback period is as follows:

Payback period = Cost of investment / Annual cash flow

Annual cash flow refers to net incoming cash flows.

Payback period example: Suppose you want to invest in a project where the investment is €50,000. The cash flow (positive cash flows) gives you €10,250 annually.

The payback period calculation is as follows:

€50,000 / €10,250 = 4.88

This means that it will take almost five years before you recoup your investment. You can then decide for yourself whether this period is too long. You might also consider whether the risks that could arise during this period are worth the investment.

The example we’ve given highlights one of the biggest disadvantages of the payback period method: it doesn’t take into account the value of money over time. Inflation reduces the value of money over time, and therefore its purchasing power. So, the investor is in the dark about how much the €50,000 will actually be worth after five years.

Here are some more advantages and disadvantages of the payback period:

Advantages

• Easy to calculate
• Possible to compare projects of different sizes
• Provides a quick assessment of the risk associated with an investment
• Helps in managing cash flow by indicating when the initial investment will be recovered

Disadvantages

• Doesn’t take into account the time value of money, i.e. money received in the future is worth less than money received today
• Doesn’t take into account cash flows beyond the payback period
• Relies on subjective interpretation of an acceptable payback period

Calculating the payback period could be seen primarily as a starting point, to see whether an investment will yield sufficient returns. To get a more in-depth understanding of the value of an investment, many investors prefer to combine the equation for the payback period with other capital budgeting techniques. The internal rate of return (IRR) is sometimes preferred, as it can provide a more detailed assessment of a potential investment opportunity.

Payback period focuses purely on the time it takes for an investment to recoup its initial cost. On the other hand, net present value (NPV) accounts for the time value of money by discounting future cash flows back to their present value using a discount rate.

Put simply, the payback period looks at how quickly you get your money back, while NPV calculates the difference between the present value of cash inflows and outflows. While both methods aim to assess the potential value of a project, NPV may offer a more comprehensive evaluation by considering the timing and value of future cash flows.

Yes, understanding how to calculate the payback period is not just helpful for companies. There are situations when calculating the payback period can be useful for your own personal finances, for example:

• Buying a car: You can compare the payback period of buying a fuel-efficient car versus a gas-guzzler based on the potential savings you’ll make in petrol or diesel costs over time.
• DIY projects: You can calculate the payback period for installing solar panels based on how much you’ll save on your energy bills.
• Further education: You can also calculate the payback period of investing in a degree course or certification, based on potential salary increases.

Investing has the potential for high returns, but it always involves some level of risk. Typically, the greater the potential returns, the higher the risks. This risk could mean losing part or all of your investment. If you’d rather avoid the risk, a savings account might be a more suitable option.

Some savings accounts, like fixed term deposit accounts, guarantee a specific return on your investment. This takes away some of the risk associated with investing while still providing competitive interest rates. You can also take advantage of compound interest to boost your returns.