Value Of A Medical Degree
Here’s Buffett on how to calculate the intrinsic value of a college education:
“Book value is the cost of the college education plus foregone earnings one didn’t receive for those 4 years. Intrinsic value is the earnings over a lifetime less what would have been made without college discount to grad day at appropriate risk rate.”
Let’s see how getting a medical degree looks in terms of its book value versus its intrinsic value.
Is Medical School Worth It?
First, let’s have our subject attend an Ivy League school to maximize the over all odds of getting in to medical school. The cost of a four-year Ivy League education is approximately $250,000 in hard costs. Buffett adds in the value of the earning not received, another $100,000, but I’m not going to include that. I’m going to assume our student goes to a good college. Total book value of the undergrad education is $250,000.
Now our student attends a wonderful medical school, again to maximize future earnings. These four years cost about $80,000 per year for a total hard cost of $320,000. In addition, we now forego a significant income.
Let’s assume we have a smart kid here who, instead of choosing biology, picks finance, graduates near the top of her class and goes on to a career in finance. This Ivy Leaguer begins her finance career at about $60,000 a year in earnings, with that amount rising quickly. At the end of four years, she will have taken home (after tax) about $300,000.
Our student’s book value (invested capital) now has an additional $300,000 invested, a new total of $620,000.
Our student is a doctor but the investing is not yet complete. She now begins a 5-year residency program where she will earn about $50,000 a year while working 80 or more hours a week. This apprenticeship adds to the investment cost of her career choice. The alternate choice of a career in finance would have provided our superstar with an income of $100,000 a year after four years in the field and the next five years will deliver another $500,000 in after-tax income. We have to add to the investment in this career the difference between the $40,000 a year after tax income for five years, i.e., $200,000, she will receive and the $500,000 she would have made in finance. That is another $300,000 invested. She now has invested $920,000.
Calculating the Sticker Price
Five years after medical school our doctor begins her career and starts making serious money as a return on her equity (aka book value, aka invested capital). Now we can calculate the Sticker Price or intrinsic value (aka ‘what its worth’) of this ‘business’.
Doctor’s incomes vary widely depending on their specialty and how hard they are working, not to mention the impact of the quasi-nationalization of their profession but let’s assume this five-year residency produces a great surgeon who makes average money in one of the higher paid specialties like orthopedics or urology. The expected income for that surgeon is about $470,000 a year; after taxes let’s call it $300,000 in current dollars. Assuming her income will increase at the rate of inflation, we’ll keep that $300,000 as a constant. In addition, she can probably sell her practice for 3 years of net income in current dollars when she retires in 30 years so in the last year we’ll add an additional $900,000.
Now we can do a calculation that tells us if we should pay $920,000 for this stream of cash. This is a discount rate calculation and the result is what we call the ‘Sticker Price’ of the business. Once we know the dollars invested ($920,000) and the dollars coming out ($300,000 for 30 years with a $900,000 payoff at the end), we need to determine a critical number, the Minimum Acceptable Rate of Return (MARR) which the rest of the world calls the ‘Discount Rate’.
We discount future cash flow because common sense says that it is better to receive $300,000 today than $300,000 thirty years from today. The key question to ask is ‘how much better?’. Well, the answer to that depends on:
- The risk you have of never receiving the $300,000 in 2044
- Some reasonable return for waiting for the money instead of getting it today.
Essentially the question becomes this: If I gave you a choice between #1: get $300,000 dollars today or #2: get Y dollars in 30 years, which one do you want, #1 or #2? Our job is to figure out Y, a number than makes the result of either choice financially the same.
A first step to an answer is to recognize that this is just the inverse of another question: What is my rate of return on a risk-free investment where I won’t get my money back for 30 years?
The answer to that question is the current 30-year Treasury bond interest rate, currently a bit less than 3%. This is assumed to be the minimum return anyone would accept since every other investment has more risk associated with it.
Since this is an alternate investment to the ‘risk free’ Treasury bond, the second step is to figure out how much risk there is and then assign that risk a premium return. In essence what we need to know is what the chances are that the $300,000 a year won’t come in. As risk goes, a doctor’s income is low on the list but still, there is risk; she could decide she doesn’t like medicine, the US government could nationalize all the doctors and reduce her income, she could get hurt and be unable to do surgery, surgeons might be replaced by robots, etc.
Read the full blog at ruleoneinvesting.com
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