September 26, 2008
What is the NPV of a JD?
Posted by Karl Okamoto

Is law school a good value? That’s the question I ask my students to figure out, hoping to teach them a bit about finance. Using crude numbers, the answer looks like a resounding “yes.” As they say in the investment business, it looks like a “three bagger.” Even if you have to put $230,000 in, you get over $700,00 back! Sweet! Hey Deans, maybe we should raise tuitions (and law professor salaries)!

What crude numbers, you may ask? Well the Wall Street Journal reported recently on salary statistics. While the median salary for persons holding just a BA has slipped to $47,240, those of us with professional degrees have gone up to $89,602. Even better, recent Labor Department numbers show the median salary for lawyers at $106,120. So, as I say to my students, think of your law degree as an annuity. It represents a payment stream that lasts for a career (say 40 years) that equals the spread between what you would have earned without your law degree versus what you can with it. Using the median salary numbers, that spread is almost $60,000. Discounted at 8%, the annuity has a present value of over $700,000. The present value of three years of tuition (at $40,000 a year), books and foregone salary (at the median) is about $230,000. So, as your stockbroker used to say about Lehman bonds, a “no brainer!”

So what’s all the brouhaha about misleading students about the value of a law school education? Well, here is where class gets fun.

According to the Department of Labor, the distribution of annual lawyer compensation in 2001 was: first 10%, less than $45,000; next 15%, $45-60,000; next 50%, $61-137,000; next 15%, 137-145,000; and top 10%, over $145,000. 2007 numbers are not much higher, but I can’t find similar granularity for my model. Now if you are standing in the ex ante position, i.e., where law school applicants stand, how do you decide what salary statistic to use in your present value model? Might it not be rational to use the “expected value” that comes from this distribution? You might immediately object that we need more data. True, while we can ballpark the first four quintiles, how do we come up with a value for the top 10% contingency? And if we already know (which I do not tell my students) that the “mean” salary was $92,000, isn’t that our answer? Mathematically, yes, but the exercise is revealing.

So much of one’s answer to the question of law school value depends on how you envision the top quintile. So the bi-modal distribution in starting salaries that Bill Henderson has identified has serious implications. The more skewed the distribution, the less helpful means and medians become. I find particularly interesting one result from my class discussions I did not expect. I assumed that students would use a very high average for the top quintile of lawyer salaries (based on AmLaw 100 profits for partner, for example), and that that would skew their present values even higher than median salaries would support. In other words, I assumed like many concerned law faculty that some students were being bedazzled by the headlines. In my in-class surveys, numbers were skewed higher than the labor statistics support, but not because of multi-million dollar outliers. They were high because so many students assumed they would earn just about twice the median income (not 50 times like partners at Wachtell).

In other words, none of my students assumed they would climb atop the Olympus of the AmLaw 100 (funny, I assume a few will). But they revealed a commonly-held notion of “average” incomes that far exceed what the numbers show us is realistic. It appears that my students, as a group, have a very similar notion of what lawyers make on average. Unfortunately, it happens to be more than what at least 90 percent of lawyer actually do earn.

I have a theory. While student are indeed savvy enough to discount starting salary stories that focus only on the big Wall Street firms and the like, these stories serve as anchors in making their judgments. And like most humans, they assume the world is evenly distributed and linear. So if multi-million dollar draws are common among big firm partners, isn’t it reasonable to assume an average law grad can do, say 10%. After all, we’re only asking to go just a few yards down the field! Nope.

At least I can take comfort in knowing that on average I'm still offering them a good deal (even if it isn't the one they thought they were getting)!

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