Capitalizing Cash Flows Reveals Attorney Risks
Top attorneys have idiosyncratic risks that are rarely incorporated into their financial plans.
Capitalizing cash flows is a good way to reveal attorney risks.As I have written about in my Company Town Risk® series, for risk management, financial planning, and investment purposes, it is very useful to look at your Total Wealth. Total Wealth is comprised of:
- Human capital;
- Real Estate, and;
In this post, I am focusing on the human capital element, which, for most attorneys, will be the dominant part of their Total Wealth.
Human capital can be thought of as the value of one’s skills, knowledge, experience, intelligence, judgement, and wisdom. There are a number of methods of valuing human capital, including: discounted present value, multiple of earnings, and capitalization rates. I will develop the capitalization rate approach here because it represents an intuitive way to compare the value of human capital to other assets on an apples to apples basis.
AmLaw 100 Partner Example
Let's assume an attorney makes $4M per year and expects to work for 20 years.Let us also assume there is risk to her future employment. AmLaw 100 firms are under pressure from many fronts, and employment, if not a firm's survival, is not guaranteed.Because of this, we need to have a discount rate for the income stream. Let's assume this rate is 15 percent. Offsetting this is the assumption that while the firm, and our lawyer’s practice group remain intact, her income can grow at five percent per year.If we subtract the discount rate by the growth rate, we get 10 percent (15 - 5). This rate is known as the capitalization rate. The capitalization rate can be thought of as a yield on a bond.By doing some simple math, it can tell us the bond-equivalent (or capitalized) value of an income stream. In other words, the amount that you would have to pay for a bond (with equivalent risk) that would give you the same income stream.
The familiar bond yield formula is:
This can be rearranged to solve for the bond price:
For our purposes, we can substitute an attorney's annual income for the coupon, the capitalization rate for the yield, and then solve for the capitalized value of the attorney's annual income (the bond price).After these substitutions the formula becomes:
By plugging in the numbers, we get:
Very simply, if we capitalize the $4M income stream at a 10 percent rate, we get a $40M value. What this tells us is that in order to get a $4M income stream you would have to buy $40M worth of a bond yielding 10 percent. Thus, the attorney’s human capital can be thought of as a $40M asset.This is very helpful in thinking through risks and investments.
Financial Planning Implications for Lawyers
In typical scenarios, a partner will have the vast majority of her Total Wealth in one asset, human capital. Furthermore, that asset will have a host of idiosyncratic risk exposures, which are, in the main, undiversifiable.Let’s make some assumptions about the other elements of Total Wealth to put this in perspective.Hypothetical Total Wealth:
- Human capital: $40M;
- Pensions: $4M;
- Real Estate: $1M, and;
- Investments: $5M.
This highlights the asymmetric and idiosyncratic risks that most attorneys face to their Total Wealth. (The law firm can be thought of as a single security portfolio.) In my experience, very few attorneys, or advisors, understand these risks, which leads to improper financial planning and investment decisions.Understanding the Total Wealth approach to financial planning often leads to surprising and counter-intuitive recommendations. I will explore these in future posts.You can find our Family Strategy Book approach to financial planning here.
 Wikipedia; s.v. “human capital”. Available at: https://en.wikipedia.org/wiki/Human_capital; Accessed July 7, 2018.