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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Comments (19)

1. Posted by Joe Leahy on September 27, 2008 @ 19:42 | Permalink

That sounds like an interesting PV/EV exercise. Anything to keep the students interested in the CorpFin portion of the class is a good idea, in my view!

Two questions, though: Is BA optional at Drexel? And do those BLS statistics you quote include lawyers who are not practicing at firms, and therefore, may possibly earn lower government salaries?

If both answers are yes, may I suggest a slightly different theory than the one you propose? Perhaps, the students did not mis-estimate...perhaps the EV of your BA class is skewed slightly towards the higher end of the salary spectrum (higher than, say, the EV of a poverty law clinic).

In my experience, students who opt to take BA (if it is optional) are those who plan to go into private practice -- either briefly (to pay off loans, etc.) or permanently. I think students who have no plans to go to a firm (ever) tend to skip BA.

Assuming that my assumption is correct, the EV for your BA students won't match the BLS statistics (even adjusting for other factors such as lawschool, geography, etc.), because the larger pool of lawyers will reflect those who self-selected themselves out of the potential for high salaries.

2. Posted by Paul from Florida on September 28, 2008 @ 7:36 | Permalink

They are, or will be, lawyers. What place does economics have in their thinking? Just look at Washington.

Other than acting, where else to such people get status without bumbing up to reality? Commercial fishing? No. Bomb squad in Iraq? No. Engineering chemical plants? No.

Even if their client goes to jail, they get paid.

What other occupation requires so little contact with the physical world at so little personal risk, and at such personal rewards, especially that Royalty and Religion are on the outs? Acting, I suppose.

3. Posted by J.Wm. on September 28, 2008 @ 7:54 | Permalink

Over the years I have met former law students as sales,engineering, marketing, or company owners. The one's that"left the law" and went into business have done very well. The one's tucked away in corporate law were a PIA to put it mildly,however one could reason with most of them. The under employed lawyer or non bar passing student with a degree is either a political wannabe or an urban Jhadist in waiting.
Good legal training prepares one well as does the classic
Most poor legal types try and use the law not as a building block but as a tool to bully.
Remember this Never mess with some one who is not afraid to loose,you get it I will earn more back. Also if I loose I will appeal and bring money lots of money as the legal cost to the client will be enornmorus as I talk real slow and all day in depositions without my Lawyer so I save money.You may win but your legal fees will be outrageous.
Y'all can not get blood outa a Turnip.
My best female student is going to be a great Lawyer once she gets out of UT Law,or a least still be a good person.

4. Posted by pashley1411 on September 28, 2008 @ 9:24 | Permalink

As the above poster pointed out, calculating value of a law degree based on incomes of lawyers is hardly worth the exercise. You are narrowing the sample to those who successfully made a transition to a career, and further like it well it enough to stay.

Probably the only data that works is to take income at set year snapshot, and then compare that to other graduates with an advanced degree background, normalized for age and gender.

This post does serve one purpose. It induces people to go into law who are not good at statistics.

5. Posted by Brent Buckner on September 28, 2008 @ 9:53 | Permalink

I think you may even be overstating the benefits of the base case.

You quote the salary differential as an annuity, but do not adjust for tax.

The salary differential will face a high marginal tax rate. Let's say 50% (future federal upper income marginal tax rates - including social security payments, future state tax rates). Present after-tax value of annuity: by your base numbers, over $350,000.

The median salary over the three years that is foregone to get a J.D. faces lower current average tax rates; let's say 25%. This gives an after-tax NPV at 8% of about 98,000.

I believe that the $120,000 in tuition comes out of after tax dollars (I don't think folks get to carry-forward a tuition tax deduction until they're earning again). After-tax NPV at 8% of about $111,000.

Net after-tax NPV of decision to get JD then $140,000. (That's noticably less than the naive method of taking your $700,000, subtracting $230,000 to get $470,000 and then applying a 50% marginal tax rate to get $235,000.)

6. Posted by Jimeo on September 28, 2008 @ 10:05 | Permalink

Good observations, Pashley and Brent.
Several of my friends (male and female) from law school (early eighties grads) have spent the majority of their adult lives in that ooccupation known as homemaker. Was law school of financial benefit to them? Factor in that some of them met their spouses at law school. What's that worth?

7. Posted by Karl Okamoto on September 28, 2008 @ 10:23 | Permalink

Buckner, excellent point. You are right. I did ignore taxes and shouldn't have.

Pashley, I agree that a better analysis would use the 'next best alternative" career rather than the simplistic assumptions I used. Also like JWm says, many lawyers become other things.

All of you may have pushed the analysis back to where I actually believe the outcome falls for a great many students - into the negative NPV. I was being a bit facetious in my conclusion.

At some point I might do the work to make the analysis something that offers meaningful conclusions. For today, I'm just happy to find a way to get some student to give PV a try and see its possible utility as a method of analysis.

I do agree with Joe Leahy that my sample may be biased, although most of the students at Drexel do in fact take BA even though it is not a required course. But Prof. Leahy's point does highlight how the math works for those of our students who know (or whom we would want to know) that they will never make even a small fraction of a Wachtell salary. It's a very important aspect of the analysis, especially when the reason for a low "EV" is that doing good just doesn't pay.

8. Posted by Sarah on September 28, 2008 @ 11:34 | Permalink

My mom was a late law school starter (I think she was 53 in her first year) and has been a practicing attorney for two years. She keeps in contact with her classmates, mostly law journal types (I can't remember what their journal's topic was) and people who were in Moot Court with her; most are younger than she is, and got better grades than she did. I'd say the typical salary for those with actual full-time jobs is $60,000 -- but they work, e.g., for Lexis Nexis doing tech support. The ones in 100% private practice are closer to $30,000, and the ones who are, like my mom, doing something (she's a part-time prosecutor in one county, a part-time private attorney in three other counties, and a part-time paralegal instructor at a community college) in between are at a slightly lower level still. Most of the ones doing private attorney work get most of their business from the rural no-full-time-public-defender system.

At this rate, they'll by and large pay off their student loans in about thirty years. Thank goodness they all really like being able to call themselves "lawyers" and being able to help really pathetic defendants get a much better outcome than they would have otherwise... especially out where I live, all these Moot Court regional champs are going a whole year between actual court verdicts. Given that most of the time, the people in question apparently did exactly what they're accused of, this shouldn't surprise me, but it still does.

(As I pay off my own undergraduate loan balance on an income-contingent plan, I'd also like to say that I hope you accounted for the interest rate on those loans. Unlike your typical law school grad, I'm fortunate in that my current gross salary is just a few hundred dollars less than my total loan balance, and even so per the Dept. of Education will probably get to year 25 of the plan and have a good $10,000 left to pay, having paid the original balance, before capitalized interest, almost three full times. I believe my mom will have about $20,000 left to pay at the end of her life.)

9. Posted by Brian Hollar on September 28, 2008 @ 11:38 | Permalink

Doesn't this depend on what you major in as an undergrad? Engineers, Computer Science, Economics, and Finance majors can do quite nicely:

At what point do the median attorney salaries kick in and how many hours per week do they work on average relative to other professions? Attorney salaries could be high on an annual basis, but are they on a per-hour basis relative to some of these other professions?

10. Posted by McAristotle on September 28, 2008 @ 15:06 | Permalink

Plus the investment in education (loss income and fees) is after tax but you still pay income tax on increased earnings... so the payback is even lower than you think.

Adjust the 3 bagger for:
1. Taxes
2. Hours worked
3. The real average earned

You can ignore the bimodality a little, after all you are discounting at 8% which is not a risk free interest rate.

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