Including Future Earnings in Your Net Worth
One aspect of net worth not captured with the balance sheet identity paradigm is future earnings. Companies are worth more than just a subtraction of liabilities from assets. Otherwise, the price of stocks (partial ownership is a company) would simply be assets minus liabilities divided by the number of outstanding shares of stock. Stock prices are typically higher than this number based on speculation about future earnings. In fact, stock prices rise and fall based on this very speculation by investors.
However, future earnings must be “brought back" to today; you need a way to figure all future earnings by arriving at a value of what those earnings are worth today. This can be done by using the present value of an annuity formula. This formula is given as:
PVA = CF * [((1 + r)n – 1) / (r * (1 + r)n]
Where PVA is the present value of the annuity, CF is the cash flow, r is the discount rate, and n is the number of periods.
Suppose that an individual expects to earn $40,000 per year over the next 20 years. What is the value of those cash flows at a 10% interest rate? Using the formula above, we have.
340,542.55 = 40,000 * [((1+0.1)20 – 1) / 0.1 * (1 /+ 0.1)20]
Therefore, the present value of $40,000 a year for 20 years at 10% is approximately $340,500. Forgetting to include future earning s can skew perception of what a person is worth today.