Payback Period Pitfalls: Investment Mistakes to Avoid

Imagine you are planting a fruit tree. You invest time and resources, hoping to enjoy delicious fruit in the future. The payback period in this scenario is like figuring out how long it will take for your tree to produce enough fruit to ‘pay back’ the initial cost of the sapling, soil, and your effort. It’s a simple calculation: when do you get your investment back?

Now, let’s say you are only focused on this payback period. You might choose a type of fruit tree that grows very fast and gives you a quick harvest. You see the first fruits sooner, and you’re happy you got your ‘investment’ back quickly. However, what if this fast-growing tree stops producing fruit after just a few years?

On the other hand, consider another type of fruit tree that takes a bit longer to mature and give you that initial harvest, meaning a longer payback period. But once it starts bearing fruit, it continues to do so abundantly for decades. If you only looked at the payback period, you might have dismissed this slower-growing tree as less appealing. You would have missed out on years and years of delicious, ongoing fruit production just because it took a little longer to get started.

This fruit tree example is similar to how ignoring cash flows beyond the payback period can lead to poor investment choices in the business world. The payback period is a method used to determine how long it takes for an investment to generate enough cash flow to cover its initial cost. It’s a measure of liquidity and risk – quicker payback often feels safer and less risky.

However, relying solely on the payback period can be shortsighted because it completely disregards what happens after you’ve recovered your initial investment. Think about two potential business projects. Project One requires an initial investment of say, one hundred thousand dollars. It promises to generate fifty thousand dollars in cash flow each year for three years. So, the payback period is just two years, because in two years you’ve earned back your one hundred thousand dollar investment.

Project Two also requires the same initial investment of one hundred thousand dollars. It generates a slightly smaller thirty thousand dollars in cash flow for the first three years, resulting in a payback period of just over three years – longer than Project One. Based on payback alone, Project One looks better.

But let’s look beyond the payback period. What if Project One, after those initial three years, stops generating any further cash flow? It’s done. Project Two, however, continues to generate thirty thousand dollars every year for the next ten years, and even beyond. Suddenly, Project Two, which initially seemed less attractive due to its longer payback, becomes the far superior investment in the long run.

By only focusing on the payback period, you are essentially ignoring all the potential profit and value that an investment might generate after it has paid for itself. You are only looking at the speed of return, not the total return. This can lead you to reject highly profitable, long-term projects in favor of projects that offer quick but ultimately smaller or even fleeting returns.

A good investment decision should consider the entire lifespan of a project and all the cash flows it is expected to generate, not just the cash flows up to the point of payback. More sophisticated investment analysis methods, like Net Present Value or Internal Rate of Return, take into account all future cash flows, both before and after the payback period, and discount them to their present value to give a more comprehensive and accurate picture of an investment’s true worth and profitability. Choosing investments solely based on payback period is like judging a book only by its first few chapters, you might miss the most compelling parts of the story that unfold later.