Friday, November 18, 2011

How Much Are You Worth? (Part 1)

Apart from tracking your periodic expenses, it is also important to have an estimate for your net worth at any point in time. While it is common for people to have cash milestones over their lifetimes (who wants to be a millionaire?), it is often more practical to have a "net worth" or "net value" target instead, especially given the significant opportunity costs associated with holding too much cash. Knowing your current net worth gives you an idea of how far you are from your financial goal and how much more you have to work to reach that goal, taking into account how many of us actually owe more than we own (see cartoon above). Also, a net worth estimate gives you a realistic measure of how much cash you can readily raise in case of an unforeseen need.

Estimating your net worth involves constructing some sort of personal balance sheet, which should very similar to the "statement of assets and liabilities" that we often hear associated with delinquent politicians and government officials. There are two key differences between this personal balance sheet and the actual balance sheet of a business or an individual's statement of assets and liabilities:
  1. We record assets and liabilities based or their current market value and not on their historical or acquisition cost
  2. Apart from financial and real assets, we also consider human capital--how much one's future earning potential is worth today
Market value vs. acquisition cost

The generally-accepted accounting practice is to record the acquisition cost of assets and just deduct an estimated deterioration in value--a practiced referred to as adjusting for depreciation. While it is often practical to use this method to record assets, at times the difference between this value and an asset's current market value--the price one can get if one sells the asset today--could be substantial. And since what we are interested in is how much money we can actually get for our assets at any given time, and not the amount we paid for the asset when we bought it (which is, in most instances, irrelevant information, if you recall one of the points in our previous post), it is more practical to use market values instead of historical costs.

One downside of using market values is that it is sometimes easier said than done. While the market value of some assets (such as cash, shares of stock, bonds, and investments in UITFs or mutual funds) are freely and publicly available, estimating the current worth of other assets like personal property (e.g., vehicles, jewelry, artwork) and real property may take a bit more effort and guesswork. The simplest way to estimate the market value of such assets is checking how much similar items are going for in the market. We can look at classifieds and publications like Buy & Sell for recent price information. If you have property in Sta. Rosa, Laguna, for example, then check how much similar properties nearby are going for per square meter, then just adjust according to the size of your own property. We can also turn to auction websites like eBay and for this information.

If current market prices are difficult to come by, then you can just always resort to the acquisition cost method. If you think your asset loses a portion of its value over time due to use or natural wear and tear, then you can estimate it's current value using this formula:

Value = acquisition cost - (number of years you have used the asset / useful life of the asset)*acquisition cost
= acquisition cost [1 - (number of years you have used the asset / useful life)]


Acquisition cost / useful life = annual depreciation

If you decide to use these formulas, you have to estimate how long you can use the asset (i.e., useful life, in years) and assume that it will be worth nothing at the end of its useful life.

Of course, if you know a bit about the mathematics of finance and the time value of money, you can always use the discounted cash flow (DCF) approach, where the current worth of an asset is just equal to the present value of the future cash flows that it is able to generate.

In Part 2, we will discuss human capital--what it is and how to estimate its value--and common items that are found on a personal balance sheet.

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