This site is all about assets. But I like to define assets really, really broadly.
As I’ve said before, many of us are millionaires from a personal balance sheet perspective – if you add the present value of your future earnings to your financial investments and couch change, the total may well exceed $1,000,000. But, unfortunately, you don’t get to relax – if you don’t work to turn your human capital (skills, powers, education, experience, etc.) into money, that asset will actually disappear. You’re rich, but only if you keep working like you’re not. Bit of a paradox, isn’t it?
Human capital and money are just the beginning, though. We hold a wide range of assets, and we need to do the very best job we can maximizing the value across our entire portfolio.
Before we get too philosophical, let’s review the three main ways to value an asset. (I’ll keep this light, but if you want to have a valuation nerd-off with me I’m definitely game).
How to Value Assets
Asset, or Cost, Approach
This one is rather simple. It just looks at what it would cost to create a similar asset (or group of assets).
Take a house: if a lot cost $100K, and you building a house on it just cost $200K, then the Cost approach would say the house is worth $300K. That may seem pretty reasonable as long as the costs are recent, but over time, even with accounting for depreciation, Cost may not be a great way of valuing assets. But it is a good method to triangulate with the others, and has the benefit of being precise, if not necessarily accurate.
Market Approach (Sales Comparison)
This one is simple, and pretty familiar to all of us. You look to the market for guidance on what an asset is worth. If a house very much like the one you want to buy was just sold for $150K, $150K is a great starting point for its value.
When there is good market data available (i.e., lots of transactions), and plenty of willing buyers and sellers, this is probably one of the best ways to value an asset.
This one gets the modelers excited. It looks at future income to be produced by the asset and bases its value on that. A common (but by no means the only) approach is the “Discounted Cash Flow” model, where you add up all of the future cash flows and discount them to today’s dollars.
This approach is certainly the most meaningful from a philosophical perspective – if an asset is something that produces a future value for you, then quantifying that future value seems a very reasonable approach to today’s valuation. But as anyone who has put together a complex financial model will tell you, the devil is in the assumptions.
(Sadly) The Approaches Are Not Equal
Often, one approach will give a better indication of value than the others. In the early 1980’s, I strolled into the neighborhood nerdery (aka comic book store) and made a major investment of $4 (Cost) for a 1965 Whitey Ford baseball card. When the next pricing guide came out, it said my card was worth $2 (Market), and sadly, the Market approach was a much better indicator of value.
This may have been the best $2 lesson I’ve ever had, but it did hurt at the time and killed my dreams of a baseball card investment empire. (I did just check on ebay, though – seems like my card is up to at least $8 after only 30+ years of appreciation. Who’s laughing now, Mr. Comic-Book-Store-Owner?)
Example: How to Value Your Human Capital
The reliance on one approach over another depends on the nature of the asset. For example, in valuing your human capital:
Cost Approach is inaccurate, if not meaningless: What it cost you to acquire your skills, powers, and education is largely irrelevant, as some graduates with boatloads of debt and useless degrees sadly find. I think many people feel instinctively that if a degree or training costs a lot of money it must be able to “pay for itself”, but that’s a very dangerous assumption. There are tons of ways to build up incredibly valuable human capital on the cheap nowadays, and there are tons of ways to spend a lot of money to acquire little or no.
Market Approach is challenging: Because we’ve wisely outlawed slavery, selling all of your human capital would make no sense because then you’d have no incentive to do anything but eat Cheetos and watch TV. Selling part of it might make sense, but despite a few fun examples here, here, and here, the market isn’t really taking off.
[Sidebar – in checking out the market for selling human capital (which sounds a bit dodgy, BTW), I came across this guy, who sold shares in himself not really for financial returns, but for guidance in life decisions. I think the return you earn is entertainment, like when the type of workout he should do or whether he gets a vasectomy comes up for shareholder vote.]
Some may argue that the salary you earn is the “Market” price of your human capital, but that’s simply not true. I suppose if you’re a Major League Baseball player with a guaranteed contract for the rest of your career, you might have the beginnings of a case. For the rest of us, you’ll need to model your salary out many years into the future to figure out the real value, which brings us to…
Income Approach is definitely the way to go: The value of your human capital is revealed as it turns into money, so looking at your future career earnings is the best valuation approach. But herein lies the ol’ problem with assumptions: how could you possibly know where your career will be in 10, 20, 30 years? What types of raises will you earn? What lucky breaks, or unlucky setbacks, will you encounter?
I’d argue you need to be less worried about producing a precise number and more focused on understanding the “model” and its critical variables. If you need to work for many, many years to achieve some number (and “unlock the full value of your human capital”), that’s very valuable information to know for your life planning. If you’ve been a bit bullish in assuming raises and promotions over the years, you need to test what happens if those assumptions don’t pan out. If your human capital is highly specialized, you may want to consider what happens if it falls out of favor (and invest in new skills as a hedge).
For a combination morality tale and demonstration of sensitivity to assumptions, I present Mr. Warren Sapp, one of my least-loved NFL players. Mr. Sapp managed to blow over $80 million in career earnings and filed for bankruptcy in 2012 (perhaps I should have started this blog earlier as I’m sure he would have been a fan). But some of his human capital remained: his Hall of Fame career gave him a lucrative analyst role on the NFL Network, and it would have been reasonable to project those earnings for many years to come. But there was a bust in Mr. Sapp’s Discounted Cash Flow model. He was arrested for soliciting a prostitute and assault earlier this year, and the NFL Network terminated him. (He’s since pleaded guilty). I’m not sure exactly what Mr. Sapp’s human capital was worth before his arrest, but I’ve got a very good guess right now.
When you think about your human capital in terms of years and years of future cash flows, hopefully it’ll highlight that you need to be as worried about cataclysmic events as you are steady salary increases. And remember those cataclysmic events can include things like a disability, sick family member, or obsolete skills – they’re not just horrible decisions like stealing money from your company, making epic social media blunders, or patronizing (and assaulting) prostitutes. Our human capital may be one of our greatest assets, but it’s also one of the most fragile.
Each asset on your personal balance sheet is different – its nature will favor one valuation approach over the others. Your most important ones, which are intangible and/or totally non-financial in nature – health, time on this earth, kids, spouse – will be very hard to assign a value. But just because it’s hard to figure out what something’s worth doesn’t mean you shouldn’t try. The good news is that precision is not required; sometimes just acknowledging that something is extremely valuable (and > or < something else) is enough to put it in a proper perspective.
I do have some thoughts on valuing these most-important of assets, which we’ll get to in the weeks (months?) ahead as my writing of posts continues at its breakneck pace. Stay tuned!
If you’d like to convince me that Warren Sapp is a really great guy, or have different thoughts on human capital, or want to purchase a 1965 Whitey Ford (Topps #330) baseball card, let me know in the comments.