Net Worth: What Is, and What Can Be
When it comes to assessing one's financial standing, the concept of net worth often takes center stage. Traditionally, individuals tend to view net worth as a static measure, relying solely on a snapshot of their assets and liabilities at a specific point in time.
However, adopting a more dynamic perspective can provide a clearer understanding of our true financial value and positioning. Let's explore how net worth is better viewed not as a fixed entity, but rather as a dynamic concept driven by cash flow and future earnings. To illustrate this point, we'll draw parallels between the valuation of businesses and individuals, employing the discounted future cash flow approach.
Beyond Static Numbers
Net worth is commonly calculated by subtracting liabilities from assets, offering a snapshot of an individual's financial position at a given moment. While this method provides a basic understanding of one's traditionally-defined wealth, it fails to capture the more practical and applicable dynamic nature of personal finances. A more comprehensive approach acknowledges the critical role of the timing, availability, and size of both present and future cash inflows and outflows in determining long-term financial strength.
The Business Valuation Lens: Discounted Future Cash Flow
To comprehend the dynamic nature of net worth, it's helpful to examine how businesses are valued. Unlike individuals, businesses are assessed based on their potential to generate future cash flows. This method, known as the discounted future cash flow approach, takes into account the projected cash flows of a company over its lifespan and adjusts them to present value using a discount rate.
By considering future earnings and applying a discount rate to account for the time value of money, businesses are valued based on their ability to generate consistent cash flow streams. This approach recognizes that a business's value is not primarily determined by its current assets and liabilities (it's balance sheet), but also by its capacity to generate useable cash flow profits in the future.
Applying the Dynamic Model to Personal Finances
Drawing parallels between business valuation and personal finances, we can adopt a similar mindset when assessing our own net worth. Rather than fixating on the current value of our assets and liabilities, we should focus on the broader picture by considering our cash flow, future earnings potential, and our strategic approach to distribution of cash flow from our balance sheet.
Cash flow refers to the inflows and outflows of money over a specified period. Analyzing our cash flow provides valuable insights into our financial health and the potential for wealth creation. By monitoring and optimizing our cash flow, we can manage the availability a steady stream of income throughout time periods, which ultimately impacts a more holistic and useful understanding of our net worth.
Acknowledging the importance of future earnings allows us to take a proactive approach towards enhancing our financial well-being. Investing in our education, acquiring new skills, and exploring entrepreneurial opportunities are all ways to bolster our future earning potential, subsequently influencing our dynamic net worth positively.
Developing a plan to be intentional about how cash flow enters our balance sheet and how we plan to get it out can make a huge difference to how we experience wealth building and usage as living, dynamic people.
What You Can Keep & Use Is What Matters
By understanding the fluid nature of net worth, we can begin to focus more appropriately on optimizing our cash flow, making wise investments, nurturing our earning potential, and being thoughtful about how changes to earnings potential will be incorporated into our assets & liabilities. Critically, we can also expand our focus to plan for intelligently getting cash flow onto and off of our otherwise static balance sheet. This shift in mindset empowers us to enjoy wealth in accordance with our dynamic, human wants, needs, and goals in life.
Perhaps you've encountered the propensity in personal financial planning to use net worth and asset totals as "goals" or "targets." But you can't spend a car, a house, or an ownership stake in a private business directly to buy food or vacations, and you can't even plan to spend a top-line pre-tax retirement account total on goods or services without allowing for timing restrictions and tax payments, first.
What's more meaningful to your plan than net worth targets is how any wealth you build can be used to support doing, being, and having things in real life. Accordingly, what's more useful to someone's plan is how much of their money they can use to support those goals, via what mechanism, and when, than what their static net worth seems to show on paper.