There’s kind of a weird saying that I’ve always thought was a bit odd, and it goes like this: “There is more than one way to skin a cat”. Thankfully, nobody (we can hope!) actually means that they’re going to remove the fur of one of our feline friends. Rather, they’re of course thinking about the concept of different ways of accomplishing the same goal.
In the personal finance arena, this saying can apply to the topic of net worth. For example, we have previously discussed many ways to grow net worth, ranging from embracing continuous learning to being persistent to building relationships. Along those lines, focusing on net worth again, there are also multiple ways we can measure it. Yes, I really think that there are different ways we can calculate our net worth or financial “value”.
Here are 3 of them, one traditional and the other two more “alternative” in nature:
The way that net worth is commonly calculated is by looking at one’s assets and liabilities, and subtracting the difference. Hopefully, the assets exceed the liabilities! If so, you have a positive net worth according to this standard method. Having more liabilities than assets results in a negative net worth.
For example: let’s say someone has a $200,000 home, $100,000 in retirement savings, and $20,000 in cash. That would equal $320,000 in assets, not net worth. If the same person had a $120,000 mortgage, $15,000 in an outstanding car loan, and $5,000 in other personal debts, that would equal $140,000 in liabilities.
Total net worth? $320,000 minus $140,000 equals $180,000. This person has a net worth of $180,000 according this approach.
Alternative Method #1 – Months of Expenses
I think this is one approach to calculating “net worth” that isn’t considered by many, and might be dismissed by others. But, it’s practical and customizable to each of us. It’s what I call the months of covered expenses method.
Really, it’s simple – and we’ve talked about covered expenses here before, albeit a long time ago. First, figure out your net worth according to the traditional method above. In this case, $180,000. Then, determine your monthly expenses. Let’s say in this case you’re spending $4,000 per month.
In this case, you have 45 months of covered expenses. That’s your net worth, or practical measure of wealth. A person with lower monthly expenses would actually be wealthier with the same exact traditional net worth, based on the customizable nature of this approach.
Alternative Method #2 – Cash Flow Valuation
Thinking back to my days in business school, I recall that there were different approaches to valuing companies. One might be a market comparable method, measuring versus other companies similar on various characteristics. Another would be a discounted cash flow valuation. Could we measure personal net worth based on discounted cash flow analysis? Sure, I think it’s possible.
The concept is to take future net cash flows and discount them back by an appropriate rate of return (inflation?) to determine the present value. This could, in turn, represent your “net worth”. Just as a company might be valued based on a discounted cash flow model, perhaps we could apply this model to us as individuals as well.
In this case, let’s say one person (we’ll call him “Person A”) might have a traditional net worth of $300,000, and another – “Person B” – has a traditional net worth of $50,000. They both might also have comparable spending patterns. Comparing them based on the two methods shared above, the first person would obviously have a higher net worth.
However, if Person B had a budding career where he was likely to earn a very high salary, and Person A had a more modest job in an unstable industry, things might be different. An objective forecast of their future cash flows might indicate that Person B might actually earn a lot more over his future years than the other guy. Thus, he might end up having more “financial value” than the other person.
Not that we want to reduce ourselves to assets that investors can trade, but you get the idea. If companies could be viewed this way in terms of valuation, perhaps the same concept could work in terms of measuring net worth of people.
Bottom Line: There are many ways to “skin the cat” in terms of calculating net worth and – by extension – wealth. It’s good to keep an open mind and view things from different angles.
My Questions for You
How often do you calculate your own net worth?
Do you strictly look at the traditional method, or do you consider other approaches? If so, what are they?
Have you ever considered the alternative ways to measure wealth as described above?