Fool.com: How Much is That in Real Dollars? (Fool on the Hill) January 18, 2000

FOOL ON THE HILL
An Investment Opinion

How Much is That in Real Dollars?

By Richard McCaffery (TMF Gibson)
January 18, 2000

"There is no such thing as absolute value in this world. You can only estimate what a thing is worth to you." -- Charles Dudley Warner

People are just like companies. They generate income, accumulate debt, and reinvest money in assets and savings.

And just like companies, people must determine how much money they really make to spend it wisely. The purpose here is to ask a simple question. Do you have any idea how much cash you're left with after paying bills? Do you have any idea how much money you net in a year? Or do you just know your gross pay, without doubt the most widely recognized and useless way of measuring income.

If that's all you know, then you're like a company that only reports annual sales figures. You have no idea of your earnings power, and no idea how your most precious dollars -- those that are truly yours after paying fixed expenses -- are being spent. Worse yet, you have no idea what those dollars are really worth to you, which means you can't make informed judgments about spending and saving money. That's where I was a few years ago.

Of course many Fools know this. It's nothing new, but for me it's such a valuable lesson it's worth hearing again. The first time I came across this topic was in Ric Edelman's book, The Truth About Money. Edelman's frank talk about money basics such as compound interest, wasted opportunity costs, savings, and debt switched on a light for me, much the same way Tom and Dave's The Motley Fool Investment Guide switched on a light regarding buy-and-hold investing.

Let's run some numbers. Say Joe X makes $50,000 annually, gross.

After federal and state taxes, and social security, Joe brings home $35,000, which means these automatic expenses account for 30% of Joe's total income. That's probably a tad low, but I'm assuming Joe doesn't have any deductions.

Next add up Joe's fixed expenses. I tried to make Joe's expenses average but these are estimates so you should make your own adjustments.

Rent -- Figure $800 a month for Joe. Edelman says shelter typically munches about 28% of your earnings. For Joe that's around $9,600.

Utilities -- $250 monthly, or $3,000 annually. Joe likes gadgets so this includes electric, water, wireline telephone, cellular phone, cable television, Internet access fees.

Food -- $80 per week, or $3,840 annually. Edelman says the average family spends about 18% on food annually, but we'll make it less for Joe since he's a bachelor.

Car payment, insurance -- $300 monthly, or $3,600 annually

Student loan -- $1,200 annually

Life insurance -- $20 monthly, $240 annually.

Gas -- $15 a week, $750 annually. Add a heck of a lot more if you're a long-distance commuter or take the metro.

Gifts and emergencies -- Edelman strongly recommends treating these expenses as fixed items since they crop up regularly. I'll be very conservative and estimate he spends $600 annually on presents.

Then add emergencies -- $1,500 annually. Examples: Car repairs and fees, plane ticket to attend a funeral, home repairs, hotel bill after being stranded in Newark, etc. Track them for a year and you'll be amazed how conservative I'm being.

Other miscellaneous costs -- $800 for oil changes, college alumni contribution, clothes, loan to sister, organizational materials such as calendars, a Palm Pilot, a subscription to The Washington Post, etc. Again I think I'm shooting low here.

Total expenses after taxes: $25,130

That means Joe's left with $9,870 of his own. You might say that's Joe's profit margin. It represents almost 20% of his gross income ($50,000), meaning if Joe was a company he'd be quite profitable.

What major expense have I left out? I've added nothing for entertainment, not a dime for drinks, poker once a week, eating out, health club fees, going to movies, tickets to a basketball game, a weekend ski trip to Killington, video rentals, a new DVD player -- the jazz of life that makes money worth having. I did this to make a point.

That $9,870 is actually worth a great deal more than that to Joe in absolute dollars because he had to generate $50,000 in revenue to make it. It took him a full year to earn that money, and he had to spend $25,130 just to be in a position to make it.

To appreciate how much that $9,870 is worth to Joe he has to start thinking in percentages, not dollars. This is one of Edelman's major points. Say Joe wants to buy a new DVD player. Fine, let's say the store charges $300. That means nothing to Joe until he puts it in his own financial terms. To Joe $300 is 3.04% of every dollar that's his to spend in an entire year.... So that DVD player better be exactly what Joe wants.

I'm not saying don't buy it. In the long term, deprivation destroys your ability to save as much as wasteful spending. But Joe should know exactly what that DVD represents in real dollars, and he should make his spending decisions accordingly.

It also makes you think twice about insignificant purchases, like snacks. I spend roughly $2 a week on coffee at the office, which adds up to about $100 annually. If I was Joe I'd be spending about 1% of all the money I make in the world on coffee. Now, if I took that $100 and invested it in an index fund that returned an average of 11% annually for 30 years I'd have $2,289.23. If I added $100 every year, I'd have $22,191 thanks to the power of compound interest.

I left off one other critical expense. Savings. If you're young, at least 10% of your money should go towards retirement, so factor that in and make the adjustments. Sure it reduces your total income, but it makes my heart beat fast knowing a big chunk of everything I earn is being invested wisely. I've found I feel much better about spending $300 on toys like a DVD because I'm tucking away cash. That's the real joy of saving money: Not just that we have it when we need it, but we feel good about spending what we have.

Have a great day.