by elmads

Introduction

Most people, if not all, want a comfortable financial life. Comfort in the sense that our finances have the capability to cover our necessities of life and still have the excess cash that can be used for leisure.

The question here is: what is the comfort number? And is it usually based on salary? Is it based on net worth? Or salary-to-cost of living? Plus, comes a statement such as “I want to be rich”, which puts in a lot of questions like, What do you mean by saying “rich”?

And usually, people answer these questions by comparing their financial status to others or the broader population. Usually this is done by benchmarking oneself to others via their salary; while this is the common way, it is not an accurate assessment of one’s wealth.

Even individuals who have a six-figure monthly income in USD live paycheck-to-paycheck. A salary doesn’t necessarily mean a high level of wealth, but what it does signal is strong financial stability to cover our necessities of life and have a lot more to spend on discretionary expenses.

Conversely, net worth is way different from a salary. It reflects one’s financial knowledge, skills, and capabilities to build wealth. It is a life skill that shows a person’s priorities in life. Their financial discipline, focus, and habits are being reflected in their net worth.

You can have a high salary with a negative net worth or have an average national salary and still have an above average national net worth. Or you can have both a high salary and a high net worth.

The knowledge and skills that are required for a certain salary, the industry (currently in the UK, finance and tech are the two highest paying industries), the supply and demand for a certain job (highly salaried individuals have certain knowledge and skills that only a few people have), the same can be said for business owners and self-employed individuals. On top of that, what you do next with your salary or cash flow after you’ve received it will dictate your net worth.

Net worth is your assets minus your liabilities. It’s certainly an interesting concept to gauge how well we are doing financially. But when we calculate our net worth, we’re looking at the present time. What if we want to look into the future? How would we somehow see how well we would be doing?

What I thought of was this. Why not investigate our personal financial cash flows into the future and discount them to our present day? Or, in short, let’s see our personal financial intrinsic value rooted on the financial habits that we’ve built today.

Instead of doing a discounted cash flow of a business or asset, we’ll be doing it to ourselves. Finding the intrinsic value of our cash flows, or, as I would think of it, our financial habits, dictates our own financial intrinsic value.

It’s assessing and analysing ourselves, like how we analyse businesses. It begs the question: if you treat your personal financial habits, strategies, and capabilities as those of a business, would you be confident enough to invest money in yourself?

Assumptions for Getting Our Personal Financial Intrinsic Value

The approach we’re taking here is no different from how we get the discounted cash flow of businesses, where we start by knowing how a company makes money, then subtracting all the costs so that we can arrive at the free cash flow of the company.

Below are two images in a compared view, where it shows the similarities of a business’ income statement and an individual’s salary statement.

Additionally, below is an infographic how we can arrive and find a company’s free cash flow.

Blog links regarding the previous infographics.

Though what I showed you is for getting free cash flow specifically for companies, we can also use the same concept for ourselves to get our personal financial cash flow.

Where it starts with your

• Gross pay
  • Taxes
  • Other deductions
• Net pay
  • Essential spending and maintenance expenses
• Free cash flow or the excess cash left that can be used for either:
  • Paying our outstanding debts
  • Discretionary spending. The non-essentials.
  • Investments and financial projects

Because we’re talking about personal finance, where debts are usually not for cash generation purposes or investments, we need to assume that we will always focus on our cash flow to pay our debt as soon as possible.

Therefore, what is left is savings for personal financial goals for the future and for our discretionary spending.

Here are my assumptions:

• The average salary in the UK as of 2023 is £26,000.
• The average savings rate in the UK as of 2023 is around 8%.
• I’ll assume that Marcus (made up name for example purposes) consistently saves 7.38% (lower than the average) of that £26,000 average UK salary, which would give us £1,920 yearly savings or £160 monthly savings.
• I’ll include the discretionary spending in our assumption as this portion of finance doesn’t automatically mean money to be spent within a month or a year, but money that can be saved now so as to be spent within 3 years (short-term financial goals).

Below is a sample snapshot of what I’ve written above, including the blog links I shared, which would give you substantial information regarding how to organise your finances like a financial mutant.

Marcus’ simple personal financial statement from gross pay to his savings. Computed in a year.

• Gross pay (Year 1): £35,616
  • Taxes
  • Other deductions, e.g., state pension, private pension, and health services
• Net pay (Year 1): £26,000
  • Essential spending plus maintenance expenses (£20,000)
• Free Cash Flow (Year 1): £6,000
  • Outstanding debts paid + interest payments (£1,580)
• Free Cash Flow Less Debt (Year 1): £4,420
  • Discretionary spending: £2,500
  • Savings (£1,920)

Compare this one with how we arrive into a company’s free cash flow, you’ll notice that It is identical, if not the same, isn’t it? Because the concepts of cash flows are universal, regardless whether we are talking about personal finance, corporate finance, or public finance. What’s important is to grasp its fundamental ideas.

To do all of these, we must have the fundamental concepts of budgeting, understanding our cash inflow and outflow (data on how we save, spend, and invest), self-awareness, and humility.

You can’t assess yourself as objectively as possible if you lack humility, or, in a harsher way of saying it, if you’re full of yourself. Extreme ego is a barrier to growth as it blinds people to thinking that they know everything in this world already, including their real selves, when that is not even the case.

Net Present Value of Marcus’s Projected Cash Flows

As an example, let’s assume that Marcus’ salary has stayed flat for the past 10 years and that he would have saved money worth £4,420 per month (both savings for short-, medium-, and long-term financial aims) in that period.

What would be the personal financial intrinsic value for Marcus?

In the previous section “Assumptions for Getting Our Personal Financial Intrinsic Value“. I wrote how I got into Marcus’ free cash flow, which is from gross income to free cash flow less debt.

That amount is the money left over after he paid for all of his essential cost of living expenses, and debts including interest.

With this free cash flow amount, he can then make decisions about where to use that money. It is either for his or his family’s discretionary spending for the now or within a year or 3 years, or invest that money in the markets or for starting his own business, or for freelancing purposes.

Therefore, the Free Cash Flow is the excess cash that he spends wherever and whenever he wants.

That being said, as Marcus has a family, he decided that a substantial portion will be allocated for his family’s discretionary spending worth £2,500, while the remaining £1,920 will be used for his family’s long-term financial goal of purchasing a home.

Here’s my question to you: Who then has the rights to Marcus’ earnings in this case? Is it just Marcus because that’s his own money? Well, yeah, that is true, but it’s not just him but also his family. Why? It is because Marcus is allocating money not just for himself but also for supporting the needs and wants of every member of the household, including his dependents. Thus, the shareholders are his family members, his wife and kids.

The family members receive the money when Marcus uses it by either:

• Giving money directly to his wife and kids
• When he treats them outside or when they travel
• Give them gifts.
• Mix of the 3

In investing, shareholders are the owners of a company. They have rights to the earnings of the company, and they receive a portion of its earnings via dividends.

It rhymes with our Marcus personal financial valuation example, isn’t it?

Now going back to the tabular form for Marcus’ personal financial valuation We assumed that from 2024–2033, Marcus will consistently be able to have a free cash flow of £4,420 a year. If we do the discounted cash flow of all the future cash flows that we project that Marcus will be able to generate, then his assumed personal financial intrinsic value today is worth £64,255.78.

What does this number mean? It’s like in the stock market: that’s the worth of the company based on the discounted projected cash flows it can deliver for its shareholders. If the cash flows do happen in the future, this means that the intrinsic value is more likely accurate, and if you bought the shares of the company for less than the amount of its intrinsic value, then you’re buying its shares at a cheaper price than its perceived intrinsic value.

In our Marcus example case, if you make him a business and he becomes a publicly listed company, if the market price is below £64,255.78, then the market price is being traded at cheaper valuations. This means that there is a good upside in the future based on the future projection of Marcus’ free cash flow. Thus, I need to keep buying, provided that it is below that market price.

The question here is, how sure are you that these projections are accurate? Where do we even base our assumptions?

Estimating Your Cash Flows

In doing an analysis of a business, we first need to understand how they make money. What does the business do to generate it? Therefore, we start with reading their financial statements. I’ve discussed this in detail in the following blog links below.

If this is the case with business valuation, then we take the same approach with ourselves.

So, I’ll ask you this. How do you make money? How do you make a living? What is your main source of income? And what are your other sources of income, if you have any?

This is where we’ll start, and it’s an easy question because that’s what you do.

For example, you work as a product marketer for a company that gives you a fixed salary based on the number of hours you work, as a freelancer who provides copywriting services where your income is based on your number of clients and contracted work with them, as a dentist who has his or her own dental practice, or if you’re employed by a company and have a side gig to boost your overall earnings.

You must think through it and understand how you make money. Then, obviously, your costs: how much does it take to sustain your basic needs? We’re talking about the essentials, so don’t take into account the non-essentials yet.

After your taxes, employees don’t have to think about this because their employer will be the one sorting it out for them. But if you’re a business owner or a freelancer, you’re most probably going to do this for yourself. Either you employ an accountant or do this independently. Nevertheless, you still must pay taxes, and you need to know how much you pay for it depending on your gross salary.

After the costs and taxes, know your debt responsibilities. Do you have debt? If yes, you might need to know the interest payments on your debts. This is the only financial cost that drains your cash flow heavily, because the longer you don’t fully pay the principal on your debt, the more the interest payments will compound over time, and sometimes it can reach an amount higher than the principal amount of your debt. Debt starts as a small hole in your financial ship where, at first, it is unnoticeable, up until water comes in, and sometimes when that does happen, it is already too hard and too late to mend it.

What I’ve elaborated on above are the basics. It’s focusing on the present and how you make money. Now, when we do projections, we usually base them on assumptions. There are several ways to do this, but the common ones are done based on the worst-case, the base-case, and the best-case scenarios.

Personally, I do projections based on the three-case scenarios. Starting with the base case

Marcus’ Base Case

Once you understand the flow of your cash and how you use it, spend it, save it, and invest it based on your financial goals, doing a personal financial projection for yourself will be easy.

If you have a steady income flow from employment, you can assume a base-case scenario where you’ll continue to have the same job within the following 10 years. This means that you will continue to receive a salary. Then you need to assume if your salary will stay flat for the whole 10 years, if it will increase by a certain percentage every year, or if it will stay flat for 4 years and then substantially increase on the 5^th year because you’re currently aiming for a higher position.

Again, these assumptions should be rooted in who you’re now, your current goals for the future, and the knowledge, skills, and habits that you have now. In short, you’re making a story rooted in a future you want to realise and how you see it happening based on your present. You then form that future based on the numbers of your finances.

To give you context, let’s use our good friend Marcus for a base-case scenario example.

Marcus works as a physiotherapist at a hospital. He has a son and wife, a renter, and a car with a car loan tied to it. He knows how to manage his money and knows every detail of his family’s cash flow, such as costs, debts, interest payments, and taxes.

In his base case scenario, we assume that he’ll continue to be employed for 10 years in the same job with the same amount of salary within that period.

In the previous section of this blog, we assumed the following for Marcus’ cash flow:

£26,000 net income (the average salary in the UK in 2023), nothing will change with his cost of living, and debt payments will continue.

His free cash flow from 2024 to 2033 will stay consistent at £4,420.

As we’re computing the present value of the future cash flows of Marcus, we need a discount rate and a terminal rate.

I’ve discussed the what, why, when, and how of the terminal rate. See the blog link below.

The discount rate is where we consider the risks of our projected cash flows; these risks are translated into percentages. I’ll write further about this in my future blogs on how to arrive at the cost of equity and the cost of capital of a cash flow-generating asset.

As of the moment, I used a 9% discount rate, based on inflation, market returns, and the risk premium.

The intrinsic value that we got from Marcus’ discounted cash flows is not without basis, because what we did here is all rooted in his present financial capabilities, habits, and strategies.

If all our assumptions about Marcus materialise in the 10-year period that we’ve projected his cash flows, then it is likely that he’ll do well over time and that his financial habits are worth that amount, the £64,255.78.

How about his best case? What would change? A lot would change.

Marcus’ Best Case

The best-case scenario is the possible outcome that we would achieve in terms of our future cash flow. So how can we approach this? It’s still the same as what we did with our base case.

We assume the best possible outcome based on our current knowledge, skills, habits, and discipline. You must be realistic when doing the best-case scenario, because sometimes people do this in an incomprehensible and exaggerated manner. I’ll elaborate about this later.

using our friend Marcus’ financial management. We’ll assume the following below for his best case:

• In 2024, we project that his net income will be £26,000 (the average salary in the UK in 2023).
• His net income will increase by 3% a year up until 2028 (the average wage growth rate in the UK varies depending on the time horizon; from 1949 to 2015, it was around 6%, but from 2001 to 2023, it was estimated to be at 3.20% per year). I’ll use 3% per year in our example.
  
  See the Office of National Statistics (ONS) UK analysis of wages and salaries annual growth rate. https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/kgq2/qna
  
• Marcus will be promoted in 2029, which will further increase his salary by 10%.
• From 2030 to 2033, Marcus’ salary will increase by 1% per year (conservative salary growth rate assumption).
• His cost of living will increase by 2% per year.
• His car loan will be fully paid in 2027.

The above image is a tabular breakdown of our stated assumptions for Marcus’ best-case scenario, while the image below is for Marcus’ free cash flow intrinsic value computation.

The best-case scenario for Marcus projected free cash flow in the future would give him a financial intrinsic value worth of £116.571.54.

Recall that the free cash flow here is the excess money (after cost-of-living expenses, taxes, financial responsibilities, and debts are paid) that can be used for saving, investing, and leisure purposes.

This means that Marcus’ financial capabilities to generate income and his financial habits of spending and saving money for himself and his family are worth £116.571.54 in his best-case scenario.

As this projection is the best case, we would assume that from now on, all the financial circumstances happening will work in favour of Marcus and his family.

This would be an absolute paradise if this pans out; unfortunately, life is full of surprises.

All good times have bad times.

Marcus’ Worst Case

The worst thing that can happen to anyone is losing their primary source of income. For most of us, it’s losing our job.

Every industry has its own problems, and every industry has its own supply and demand for employees, which are all dependent on the current state of the economy and the job market.

Estimating the worst possible case is frightening because we’re forced to think of the worst possibility that could happen to us financially, which for most people is just anxiously difficult to even think about.

But, without acknowledging the fact that our lives are not meant to be lived in perfect and constant happiness, we’re already sheltering and fooling ourselves into the realities of life.

There’s a difference between knowing and acknowledging hardships; the former is just the idea that life is hard, while the latter is taking action to prepare ourselves on how to handle life’s intricacies when it starts taking us to the bottom.

It involves developing resilience, problem-solving skills, and a mindset that can navigate life’s complexities. It’s not just about being aware of difficulties; it’s about being proactive in building the strength and skills needed to overcome them when they arise. This proactive approach can lead to greater adaptability and a more positive response to life’s ups and downs.

This is also the reason why worst-case scenario projections are done in the financial space. It serves as a reminder that disasters can happen at any time, and if they do, somehow you would have planned to handle such an event. Though it can push back your progress substantially, at least you’re not fully destroyed and devastated by it. Imagine the alternative: being unprepared just because you don’t want to acknowledge the possibility of hardships.

In Marcus’ case, he works as a physiotherapist in a hospital. Healthcare is one of the industries with the highest demand, regardless of the current environment, pandemics, wars, and natural disasters. Though not all jobs in healthcare are created equal, there are some that are more highly needed than others.

Marcus considers that his worst-case scenario would be losing his job, but he deems that the odds of it happening are too low, at less than 5%.

He thinks that his job is more secure than most jobs in other industries. Therefore, he decides that his doom and gloom scenario is where his salary will stay flat for 10 years while his cost of living continues to creep up by 3% a year. His car loan will be paid after 10 years as the rising cost of living increases, which squeezes his salary that will stagnate over the 10-year period.

Below are the tabular form and DCF of Marcus’ worst-case scenario.

From 2031 to 2032, Marcus free cash flow is less than the amount he needs to pay for his outstanding debt and interest payments. This means that he would need to find a way to raise additional money to pay for it.

Usually this is done by taking on additional debt, either from credit cards or personal loans to other people, but that’s a poor financial decision as that’s just kicking the can down the road. The problem is only solved in the short term; unfortunately, it inflates the predicament in the long term.

Another way is by doing side gigs or buying and selling stuff. A person can start by selling stuff he or she doesn’t use at home. Things that have been collecting dust for ages

Or, if a person has saved money and has a good net worth, then that person can use his or her net worth to sustain his or her basic needs.

Things will be harder for Marcus once 2033 comes, because his cost of living now supersedes his income. He would need additional income sources when that time comes or tap into his net worth.

If Marcus loses his job, then his cash flows will be all in the red for the years where there is no income in flow and his intrinsic value would obviously be in the negative as well. The approaches will be the same: find additional income through side gigs, just kick the can down the road by taking on debt, tap in his net worth, or do a mix of the three.

What will dictate someone’s financial prowess in the hard times is usually what he or she does during the good times. As like what the squirrel does, stash nuts away before the winter comes.

Be Realistic with Your Personal Financial Projections

Everyone has their own bias, and being aware of where you are most likely biased is of major importance.

All valuations in finance have an inherent bias towards the person doing the financial analysis. It’s because we’re humas, who are full of emotions and have individualised personalities and beliefs.

These things substantially influence our decision-making and valuation processes. Either we tend to be overly optimistic or pessimistic in our projections based on our beliefs, emotions, behaviours, and experiences in life.

This is what makes valuation hard because it makes it uncertain and unpredictable. We prefer 1+1=2, where there is only a right or wrong answer. Unfortunately, with valuations, there’s none. We must be comfortable with uncertainty and get used to making calculated decisions based on our understanding of the facts presented to us and also on the knowledge and experiences we have.

When doing our own personal financial projection, it is important to be aware that we will always have a bias in doing it. Being mindful about our biases gives us that third person view and awareness if we’re being unrealistic or realistic with our projections.

You see, if you become unrealistic about the facts and financial habits that you have now, it’s most likely that your future assumptions about your cash flows will be highly skewed.

Let me give you an example. Let’s say your current habits are more likely tilted towards spending money than saving money, and that you tend to take on debt every time you spend. The downside of your habit of using your credit card is that you forget to pay it before the due date; hence, you pay interest on your credit card debts.

This would eat a portion of your free cash flow, which further shrinks the amount you’ll be able to save your money on. Plus, you’ve been inconsistent with saving money; sometimes you are only able to save every 2 to 3 months. The rest of your free cash flow is allocated fully to paying debts, interest, and leisure.

When you did your best-case scenario projection, you based your assumptions that you’d be able to generate a good amount of free cash flow in the future, but you didn’t consider the debt payments. This would give you a false amount of your own intrinsic value. See Below.

In our example above, this person’s past 5 years actual cash flow statement (from Fiscal Year 2019-2023) showed that he was still consistently raking in debt due to the habit of spending through credit cards without paying it immediately for months, which accumulated the interest payments over time.

When the best-case scenario was done, the unpaid debts of today weren’t taken into account for the future, which already gives a false assumption because the debt wasn’t even fully paid yet, so with 100% certainty, the same debt will continue to be paid in the future.

Habits don’t change immediately; I’m not saying that it’s impossible to change them, but it surely does take time. As Warren Buffett said, “Chains of habit are too light to be felt until they are too heavy to be broken”.

Remember this. Your own estimated intrinsic value is neither your salary nor your net worth. What it reflects is your personal financial value based on your current financial habits and earnings capabilities, which are all rooted in your current knowledge, skills, mindset, habits, and discipline.

“You don’t create your future. You create your daily habits, and they create your future.”

—Randy Gauge

Putting Personal Financial Valuation Concept into Context

Knowingly or unknowingly, our income has a specific purpose that differs for every one of us. Like for providing the necessities of our lives and for long-, medium-, and short-term financial goals. 

These financial goals of ours change as we grow older and commit to further responsibilities in life, such as being independent from your parents, having a job, having your own home, having your own car, having your own belongings, being a husband or wife, a father or mother, progressing in your career, taking care of elderly parents, a career change or specialising in your career, having grandchildren, and being elderly ourselves in the future.

Whether if we like it or not, for every change in our lives as we walk the path of time will always have money tied to it. And somehow our ability to rely on money changes as well, from relying on our parents to being financially independent ourselves, to becoming a provider of financial support, and to, hopefully, being fully financially independent by not relying on anyone for financial support in our elderly lives. Even after a few days we leave this world, money will still play a role in funerals and either burial or cremation.

This is the same with businesses; they have their own life cycle, from the introduction stage to high growth, then maturity, and finally to their declining phase. Capital-wise, it also changes for them. From relying on outside capital for survival to becoming a cash-generating business and to its end of life by selling all its assets to liquidate the company or selling the business to be acquired by a larger company,

As with our personal lives, a company’s financial priorities also differ as they grow older day by day.

To understand how to invest in companies and know their intrinsic value based on their lifetime, we need to put this into the perspective of personal finance.

Think of it like this: you’re either dependent on a person’s cash flow, or you have a dependent individual on your cash flow, or you’re the sole owner of your own income.

• If you’re dependent on another person’s income to sustain yours, then you’re a shareholder in that person’s cash flow because your life is dependent on that person’s earnings capabilities and money management.
• If this is not the case, then most probably you’re an individual who has dependents on your income flow.
• Or maybe you’re one of the few people who doesn’t have any responsibilities yet for himself or herself, but that wouldn’t last forever. As of the moment, you’re just the sole owner of your income flow.

Remember that your cash flow projections are solely based on where you are in your financial journey, your life priorities, your current knowledge, skills, habits, and discipline, not just on how you handle money but also on how you make money.

This is the reason why upskilling and expanding your knowledge, either in your chosen field or across different fields, is important to increase your cash flows and to also utilise it efficiently. All these effort and hassle are for purposes that you deem essential in your life, things that are greater than yourself.

To Sum It Up

◾Your salary doesn’t necessarily reflect your level of wealth, but what it does signal is strong financial stability to cover your necessities of life and have a lot more to spend on discretionary expenses.

◾Your net worth reflects your financial knowledge, skills, and capabilities to build wealth. It is a life skill that shows a person’s priorities in life. Their financial discipline, focus, and habits are being reflected in their net worth.

This is the reason why you can have a high salary (you’re good at making money due to your financial earnings capabilities or you have a set of knowledge and skills that put you at the top of your game, which is reflected in your salary), but a low to negative net worth, which can also affect your personal intrinsic value. As Robert Kiyosaki wrote in his book Rich Dad, Poor Dad, a person can be highly educated, professionally successful, and financially illiterate.

◾The third one is what I call your financial intrinsic value. It is the synergy of your salary and your net worth. Where your financial earnings capabilities and your personal financial management work together to show your current financial intrinsic value based on the prospects of future cash flows

Though all projections have a high degree of uncertainty and error, the projections we make of our finances must be rooted in our current sets of financial habits, knowledge, skills, and discipline, not on a mere pessimistic or optimistic view of our future selves.

What you reap, you sow.

• You can’t reach an executive position in your company if you don’t do anything today to exert extraordinary effort to reach that goal.
• You can’t do weightlifting if you’ve never lifted your entire life, have not set foot in a gym, or just keep on delaying your plan to start training your body today.
• You can’t reach your net worth goal if you spend all your cash flows on leisure and on paying debt without exerting a daily effort to build the habit of saving or repaying all of your debts as soon as possible.
• You can’t realise your athletic pursuit of running a full marathon if you just sit on the couch all day on your days off.
• You can’t become a top sales agent if you’re not taking small actions to do it.

It’s the same right now. Your life today is the by product of the decisions and habits you made in the past 5 or 10 years.

How you approach your personal financial valuation is similar to how we analyse businesses. Provided that you understand the business, their drive, their goals, how they move around their money, and their plans for the future. With these, you’ll be able to make an investment analysis and make your own independent investment decision.

It’s funny how a field of money and numbers is not what it seems—the boring old stuff that people think is only for math-loving individuals.

In fact, what lies under the numbers is the motivation of people and groups of people. It just so happens that numbers put into perspective almost everything in our world.

Math, Finances, Behaviour, Philosophy, and Psychology, who would have thought that the multidisciplinary path opens a lot of doors. Unfortunately, instead of understanding more, you’ll realise that you still don’t know a single thing about anything.

“You don’t know anything, Jon Snow”. And it is, indeed.

Knowledge is my Sword and Patience is my Shield

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.