By Keith Whitcomb
Over the years, estimates of the value of the human body have ranged from $585 to $45 million. It depends on whether your body is considered to be 98% water, or a collection of valuable "components." This "whole [components] is greater than the sum of [base chemical] parts" view, attributed to Aristotle, can also be seen in the valuation of companies. There is a firm's book value as defined by a balance sheet (sum of parts), and a market capitalization which is based on a company's stock price.
Unfortunately, for some investors, Aristotle's observation on the synergy of the "whole" is not always true. At times, the sum of the parts can be worth more than a poorly managed company's market value. That said, the difference here is that the market capitalization of a company looks beyond the value of current assets and liabilities. It theoretically evaluates what the company will financially achieve in the future. This analytical approach can also be applied to the "body" of your finances. Why should you care? Because it enables you to move from evaluating history to planning for the future. Let's take a look.
A common way to measure your wealth is by calculating net worth. Net worth (assets - liabilities = net worth) is essentially a financial snapshot of where you are today. But is this "net of the parts" approach the most relevant measure of what you are worth? Here are a few reasons why it may not be.
The economic value of your "human capital" is not included in net worth. I'm not talking about an estimate of the value of your body "components," but rather future income from employment. As a result, a person can make $25,000 per year or $250,000 and it will have no impact on their net worth.
Two people each have a $100,000 home mortgage, but at different interest rates, e.g., 5% and 3%. What shows up in a net worth calculation? The same liability. There is no accounting for the difference in interest expense.
It's estimated that the value of a new car decreases by 10% as soon as you drive it off the lot. The result is that your net worth instantly drops by the depreciation of the car. How about leasing? Even if your lease payments are identical to your auto loan payments, a lease won't impact your net worth because it isn't considered a liability.
So, if you are working, have a home mortgage, or drive a car, it probably makes sense for you to use something in addition to net worth to measure your worth.
Capital budgeting (a corporate finance tool) is a process that evaluates business opportunities by estimating future cash flows generated from investments in factories and equipment. You can use this same technique to supplement net worth as a measure of your finances. To get started, the first step is to calculate your net worth. Here are some common items included in the net worth calculation:
Assets: Cash, bank accounts (checking, savings, CD), investments (brokerage accounts, 401(k), IRA), real estate (personal residence, investment properties), other (vehicles, furnishings)
Liabilities: Credit card balance(s), auto loan, student loan, home mortgage and/or HELOC.
The next step is to list out major, multi-year positive and negative cash flows associated with your household finances. These are known, expected, or better yet, contractual types of revenue and expense items.
Segregate your cash flows into the following two categories:
Sources: Positive cash flows -- Some examples include wages, investment income, annuity and pension payments, and Social Security.
Uses: Negative cash flows -- These include food, shelter, and interest expense on credit cards, home mortgages, auto loans, and student loans.
Next, locate the cash flows in proximity to their relevant asset or liability by totaling the multi-year flows into single balances.
Here is a template of how that may look for a married couple with two cars and a house in their early 30s with the following financial circumstances:
Statement of Financial Resources
As of 12/31/2019 - Projected for 10 years ending 12/31/2029
Market Value As of 12/31/2019
Cash in bank and taxable brokerage accounts
Retirement accounts, e.g., 401(k), IRA
Outstanding balance as of 12/31/2019
Payments through 12/31/2029
Credit card - Payments of $119 / month for 3 years ending 12/31/2022
Auto #1 Loan - Payments of $406 / month for 5 years ending 12/31/2024
Auto #2 Lease - Payments of $200 / month for 3 years ending 12/31/2022
Home Mortgage - Payments of $966 / month for 30 years ending 12/31/2049
Real Estate Taxes - Payments of $9,000 / year for 10 years.
Net worth, as of 12/31/2019: $169,000
Cash Flow Adjustments to Net Worth
Income - $100,000/year for 10 years
Household Expenses - $75,000/year for 10 years
Interest, lease & real estate tax - from Payments shown above
Retirement savings - $10,000/year for 10 years
401(k) match on retirement savings - $2,000/year for 10 years
Pay down of debt - from Payments shown above
Cash Flow - Positive (Negative) for the 10 years ended 12/31/2029: ($71,779)
Net Financial Resources as of 12/31/2019: $253,805
Cash Flow = Sources (Income + 401(k) Match) - Uses (Household Expenses - Interest - Lease - Real Estate Tax - Retirement Savings - Payment of Debt)
Net Financial Resources = Net Worth +/- Cash Flow + Increases in Assets (e.g. Increase in Retirement Savings) + Decreases in Liabilities (e.g. Decrease in Debt)
You may have noticed that the future cash flows are shown "gross" and have not been discounted. For this article, round numbers have been used to make it easier to understand the calculations.
The 10-year time frame was chosen as a balance between not enough information and too much speculation. However, there is no magic behind the ten-year period, so you can adjust it based on the quality of your data.
Income taxes should be incorporated into estimates of future cash flows, a replacement vehicle could be added after the initial lease expires, sub-schedules to support large line items like "Household Expenses" can be developed, and so forth. These and other refinements in the calculation will be explored in future articles.
So how does this calculation help you? The idea here is to expand from measuring where you are today, to focusing on what to do about tomorrow. Here are a few observations that the analysis highlights:
Negative Cash Flow: Negative cash flow means that you are over-spending your means. Positive cash flow indicates a surplus of income over spending. By design, the statement focuses attention to major "capital" line items in your household finances to help you determine how to eliminate this deficit by focusing on "the big stuff."
Home Mortgage: Current mortgage rates have dropped down to about 3.5%. What would a refinancing do to improve your financial circumstances?
Outstanding Balance As of 12/31/2019
Payments through 12/31/2029
Home Mortgage - Payments of $808/month for 30 years ending 12/31/2049
The beauty here is that the value of the lower interest rate flows through to the calculation of Cash Flow and Net Financial Resources. Net Worth on the other hand remains unchanged, and does not show the impact of restructuring your debt.
Net Worth as of 12/31/2019: $169,000
Cash Flow - Positive (Negative) for the 10 years ended 12/31/2029: ($52,819)
Net Financial Resources as of 12/31/2019: $279,812
Household Expenses: A benefit of this analysis is to give perspective to the materiality of very large expenditures. Given the size of household expenses, trimming them by about 7% will eliminate the remaining $52,819 cash flow shortfall. Once again, this change is not reflected in the Net Worth calculation, but does improve Cash Flow and Net Financial Resources as shown below:
Net Worth as of 12/31/2019: $169,000
Cash Flow - Positive (Negative) for the 10 years ended 12/31/2029: $0
Net Financial Resources as of 12/31/2019: $332,631
Are your financial resources growing? Do you have enough money to support your lifestyle? By blending a number of accounting concepts, the Statement of Financial Resources consolidates the evaluation of your finances into three summary measures (Net Worth, Cash Flow, and Net Financial Resources) which provide you with the insight needed to make the big financial choices in your life.
About the author: Keith Whitcomb MBA, RMA is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.