Rule #1 Finance Blog

With Investor Phil Town


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.

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Is Medical School Worth It?

First, let’s have our subject attend an Ivy League school to maximize the overall odds of getting into 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 it’s 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:

  1. The risk you have of never receiving the $300,000 in 2044
  2. 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 that makes the result of either choice financially the same.

The 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.

Whole Foods…

Whole Foods faces this sort of problem on a regular basis when considering whether to open a new store.  They can make a good estimate of the after-tax cash flow for the next 30 years, the investment in the new store and the risk of not making the cash flow they projected.  Their standard risk adjustment is to discount the future cash at 9%; this is their MARR, this is the amount they require as a repayment of capital and to account for risk.  Let’s use that 9% for our MARR and see how the Whole Foods discount rate plays out for a surgeon:

Excel Formula: Calculate the Present Value of a Stream of Equal Payments

The excel formula to calculate the present value of a stream of equal payments is:

=PV(rate, nper, pmt, fv) where

rate = 9%,

nper = 30,

pmt = 300000 and

fv= 900000

We do the calculation and here are the results:

Present Value (aka Sticker Price) = $3,150,000.

MOS (50%) = $1,575,000.

Investment in surgeon business = $950,000

Now we compare the present value or Sticker of a career as a surgeon with the price being charged in the market to have that career and we see that $3 million is quite a lot higher than the nearly $1 million it will cost.

There is a nice Margin of Safety that protects the investment from much of the risk.  Therefore, becoming a surgeon still potentially pays well enough to choose it.

By comparison, an Obstetrics doctor will average $257,000 pre-tax and $166,000 after tax.  The residency for OB-Gyn practice is four years.  The shorter time in training reduces the investment from $920,000 to $860,000.  This career has a Sticker of  $1,740,000.  The present value of an Obstetrics doctor’s income does justify the investment and it still has a good MOS.

The lowest paid doctors are the family practice physicians; $178,000 pre-tax, $110,000 after tax.  The Sticker on this practice is $1,150,000 and, with three years of residency required, the investment is $800,000.  It’s still a buy but the recommended margin of safety is gone.  This might at least partially explain why it is getting harder and harder to find residents for primary and family practice.  Kids might not know about doing this financial analysis but their gut tells them something is wrong with investing $800,000 to make $110,000 a year.

This analysis is interesting from an investor’s point of view in that it indicates that the income paid to some doctors is only marginally enough to make sense of the financial investment, not to mention the time and effort it takes to succeed.  It occurs to me that some students who have the ability to become doctors will realize that it might make more sense from both a financial and labor perspective, to simply, for example, become a high school teacher who, after 20 years, can make $110,000 a year, working only 9 months a year, an equivalent income of over $100,000 a year after tax.

One must wonder at the wisdom of a system that pays experienced family physicians and tenured high school teachers an equivalent income despite the vast difference in the minimum work ethic, IQ, and investment required to succeed.

On that point, the 50th percentile IQ of high school teachers estimated by a University of Wisconsin 2002 study of IQs by profession, is 107.   The 50th percentile IQ for doctors according to the same study is 120.  This is also the highest average IQ of all professions.  But by all accounts it isn’t enough to be smarter to get to be a practicing physician; it takes a huge amount of work and sacrifice, an effort that only a very small portion of the population is willing to exert.


My conclusion is that if a high IQ and a great work ethic is the essence of what makes for a financially successful life, doctors should be at or near the top of the pile.  The fact that doctor’s income is dropping while teacher’s income is rising to the same level is a prescription for a disaster in medicine in the future. I’ve created calculators that you can use for free to tell if a business is worth investing in. Click the button below to learn more.

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