How can general managers increase the value of their franchise?

Phew. It has been long time coming, but you can now heave a big sigh of relief as I publish the final of my four-part series on valuing baseball clubs. If you are coming to this series fresh (where have you been?) I urge you to read part 1, part 2 and part 3 first.

Last time we looked at how to use a technique called DCF to justify the price paid for a baseball franchise; specifically we looked at the Milwaukee Brewers. The beauty of using the Brewers as a case study was that they were sold in 2004/5 so we were able to compare our model to the actual sale price. And, guess what? To the surprise of no one we managed to arrive at a valuation very close to the purchase price by using a few informed (some would say wild) assumptions.

Today I want to spend some time thinking about the levers that baseball executives and owners can pull to maximize the value of their franchises and try to bridge the difference in value between two teams in similar markets, one of which is well run and the other of which is badly run.

Last time we said that every $1 increase in profit results in an increase in valuation of $14. That gives a lot of scope for executives to boost the worth of poorly run franchises. Simply put, there are two things an executive can do: boost revenue or cut cost.

Let’s start with the revenue side of the equation.

Revenue

We know from part 2 that there is a reasonable degree of certainty around MLB revenue numbers, more so than for cost numbers. So how does a typical major league club’s revenue split across its constituent components?

Tickets       39.0%
Concessions   16.4%
TV            16.1%
Post season   1.3%
Other local   7.0%
National      20.3%

The first thing to notice is that local revenue accounts for close to 80 percent of all revenue. That is important for a couple of reasons. First, it places a limit on a franchise’s revenue potential. By virtue of operating in New York, which is a large market, the Yankees have a much higher revenue-generating opportunity than, say, the Brewers do. Short of relocating, the Brewers are constrained in earning power by the number of people who can attend games, buy hot dogs, park at the ballpark or watch the team on FSN.

Second, it means that individual teams actually have a lot of influence on the amount of revenue they make. If they can attract more people to the park, make their team more exciting or move to a new stadium with better facilities, then the franchise will trouser most of the extra revenue itself. This is doubly important when you consider that the national TV deal doesn’t discriminate among different franchises; the Yankees get just the same as the Brewers.

There are three factors that general managers and owners should consider when thinking about boosting franchise valuation.

  1. How close is the team to its revenue ceiling?
  2. Is the team maximizing money from its park?
  3. What is the most cost-effective way to build success, and with that an attractive product for fans to consume?

Where is the revenue ceiling?

How can we identify franchises that are falling short of their revenue potential? The first thing to do is to size each local market. There are a number of ways to do this, but the most intuitive is to either look at metropolitan population or size of TV market. After tinkering with each I discovered that we get the best representation by combining the two factors in to a composite ranking. Here are the adjusted revenue and TV data:

Team             TV             Population
Yankees          4,323,401      12,441,446
Mets             3,043,549      8,758,419
Dodgers          2,978,932      8,692,750
Phillies         2,941,450      6,188,463
Red Sox          2,372,030      5,819,100
Angels           2,632,178      7,680,895
Nationals (Expos)2,272,120      7,608,070
Astros           1,982,120      4,669,571
Braves           2,205,510      4,112,198
Cubs             1,840,621      4,878,570
Tigers           1,938,320      5,456,428
Diamondbacks     1,725,000      3,251,876
Rangers          2,378,660      5,221,801
Devil Rays       1,755,750      2,395,997
White Sox        1,614,399      4,278,970
Marlins          1,538,620      3,876,380
Twins            1,678,430      2,968,806
Mariners         1,724,450      3,554,760
Rockies          1,431,910      2,581,506
Athletics        1,047,208      3,092,703
Giants           1,336,362      3,946,659
Indians          1,537,500      2,945,831
Orioles          1,097,290      7,608,070
Pirates          1,163,150      2,358,695
Cardinals        1,228,980      2,603,607
Padres           1,030,020      2,813,833
Royals           913,280        1,776,062
Reds             886,910        1,979,202
Brewers          882,990        1,689,572

We can use simple regression to work out the relationship between size of population and revenue. Running a multivariate regression with both TV market and population as variables will suffer from extreme correlinearity so won’t work. What will work, however, is to build two separate models and add the results together. Here is actual revenue vs predicted revenue for population, TV market and a composite:

                                 Predictions
Team               Rev       TV      Pop  Composite    Diff
Yankees            277      238      236        237      40
Mets               195      197      199        198      -3
Dodgers            189      195      199        197      -8
Phillies           176      194      174        184      -8
Red Sox            206      175      170        173      33
Angels             167      184      189        186     -19
Nationals          145      172      188        180     -35
Astros             173      163      159        161      12
Braves             172      170      153        162      10
Cubs               179      158      161        160      19
Tigers             146      162      166        164     -18
Diamondbacks       145      155      144        150      -5
Rangers            153      176      164        170     -17
Rays               116      156      136        146     -30
White Sox          157      151      155        153       4
Marlins            119      149      151        150     -31
Twins              114      153      142        147     -33
Mariners           179      155      147        151      28
Rockies            145      145      138        142       3
Athletics          134      133      143        138      -4
Giants             171      142      151        147      24
Indians            150      149      141        145       5
Orioles            156      134      188        161      -5
Pirates            125      137      136        136     -11
Cardinals          165      139      138        138      27
Padres             158      132      140        136      22
Royals             117      129      130        129     -12
Reds               137      128      132        130       7
Brewers            131      128      129        128       3

A negative number implies that a team under performs its median revenue potential, while a positive number indicates it over performs. This list makes intuitive sense. The Nationals only recently moved to the capital, so we’d expect that they would have some way to go to build and exploit a fan base—the team needs to become established and start winning. The Red Sox and Yankees are marketing behemoths, so it is no surprise to see that they outperform their revenue target. The Angels are interesting—looking at this it is obvious why they want to tap in to the LA market more!

The correlation between market size and revenue is reasonably strong with an R of 0.78. This won’t surprise anyone: the larger the market, the greater the revenue opportunity.

A lot of franchises are within $10 to 15 million of their potential, which indicates there isn’t a whole lot more they can do to generate vast quantities of new revenue. However, because fixed costs are low, if an owner can find just $5 million of revenue enhancement, that can translate to an increase in value of around $70 million. That doesn’t sound like much, but it is actually a heck of a lot. That equates to boosting attendance by 2,000 per game (or about 5 percent for most teams) for every game, or it equates to selling an extra 350,000 baseball caps in your own stadium. With some canny marketing, clever owners will eke out new opportunities here. Let’s call it $1-2 million worth.

Valuation swing = $30m

New stadia

Stadiums affect both the revenue and cost lines.

One surefire way to boost revenue in the short term is to knock up a new, publicly financed stadium. Think about it. There is a good excuse to increase ticket prices, fans flock to the ballpark for the novelty factor, more expensive concessions can be served and advertising space can be better displayed meaning higher rates.

What’s more is that new stadiums often come with a heavy dose of public subsidy so the franchise doesn’t even have to stump up the cash. The Mariners are an example of a team that has won from an attractive stadium deal. The Mariners received $372 million in public money for Safeco and despite having to stump up for cost overruns, they get to keep all money generated by the stadium including when it is used for non-baseball events. Another plus for teams is that under the collective bargaining agreement they can deduct any building costs from any revenue sharing obligations. Nice.

Baseball Prospectus, in its book Baseball Between the Numbers, has done some great analysis on how new stadiums generate extra revenue. There are a couple of factors to consider. First, fans flock to a new ballpark because of the novelty factor. They want to see the shiny new scoreboard, the 80-foot Jumbotron and the sexy city skyscape design. BBTN reckons produces a revenue bump of $17 million spread out over the first three years of the stadium. Second, is the impact of stadium quality, which allows the franchise to increase the price of anything and everything that moves. ESPN produces stadium ranking each season. A stadium is ranked out of 100. Again BBTN estimates that a new stadium that scores 85 on the ESPN will generate $19 million in additional revenue than a decrepit stadium that scores 60.

Wait a minute … if $1 of additional money a club earns equals $14 of value, doesn’t that mean that new stadiums massively increase a club’s value? Not quite. Don’t forget that revenue does not equal profit. There are additional costs to be accounted for. From our analysis of when the Brewers moved to Miller Park not only did they have to pay off loans covering construction they also added a chunk of overhead to maintain and manage the new stadium. In all, it probably contributes a maximum of about $5 million in profit to a team. That equates to $70 million in value and is the reason why the Twins are only valued at $180 million in the latest Forbes standing. That was before the new stadium deal. Now that it is secure, look for their value to increase commensurately when Forbes releases its latest valuations in April.

Valuation swing = $70 million

Building success and payroll

Improving marketing and building new parks are all well and good, but they feel a bit superficial. There is, of course, one other very important way to get the fans through the turnstiles and that is by winning.

It makes sense, right? Success on the field is usually rewarded by an influx of fans spending money at the ballpark and more interest from local media and sponsors. Who wouldn’t want to be associated with a winner?

How do we define by success? A trip to the postseason every year? Or perhaps every five years? Or perhaps finishing above .500? OK, perhaps not the last one. The point is that it is subjective, but what fans crave is contention. That is why the wild card is good for the game—it created more excitement and meant that more teams were contending. Sure, every so often a postseason berth is a nice fillip to the fans but as long as the team is contending they’ll be happy.

Nate Silver, of Baseball Prospectus, has done a lot of work on how the value of a win varies depending on the talent level of the team. Nate found the following:

  • Below 80 wins, marginal value of an extra win is $0.7 million
  • At 86 wins, marginal value of an extra win climbs to $2.5 million
  • Marginal value of an extra win peaks at $4.5 million at 90 wins
  • After 97 wins marginal value of an extra win drops to $0.7 million again

The sweet spot is around 85 wins. It is at this point that teams have a reasonable chance of making the postseason, and this will create excitement among the fans. It is also the point where spending that extra $1 million can add real value to the ball club. Getting to the playoffs is very lucrative; no wonder owners are willing to spend like Elton John to get there.

The general manager’s job is to work out how to best deploy resources to maximize revenue yet contain cost. Should a team invest in player scouting and development at the expense of payroll in order to build a winning team?

Based on Nate’s work I have estimated the cost and value of maintaining a 90-win team if you are a 75-win team.

  • 75 wins = $35 million
  • 90 wins = $65 million
  • 15 wins = $30 million = $2 million/win

You need to acquire talent either through trade or through free-agents that is worth less than $2 million a win. Our own Dave Studeman shows that free agents cost $4.5 million a marginal win. Adding a free agent would destroy value for this team.

What about moving an 85-win team to a 92-win team

  • 85 wins = $45 million
  • 92 wins = $75 million
  • 7 wins = $30 million = $4.5 million/win

In this case adding a free agent does make sense, but it doesn’t add any value to the team (because cost = value). However, trading prospects for cheaper pre-arbitration or arbitration-eligible wins would be a good strategy. For the 75-win team the best option is to invest in scouting, statistics and player development to try to add 10 wins to get into the 85-win sweet spot.

Remember here we are talking about talent, not luck. Luck can mean that a team that adds a free agent flukes a playoff spot, which fills the coffers.

Adding free agents rarely makes financial sense even if it allows a team a run at the playoffs. Wheeling and dealing other talent makes more sense. Also, once a team has added a free agent that is it; it is impossible to extract the team from the contract. If the player is shipped on, the selling team normally has to pick up some portion of the contract.

Valuation swing = $0 million (it is difficult to add wins at little cost)

Final words

Smart management both on and off the field can have a dramatic impact on value. The difference between a club run well and one run poorly on and off the field can be as much as $70 million.

FACTOR                    SWING
Better management         $30 million
Stadia                    $70 million
On-field performance      $0 million
TOTAL                     $100 million (max)

That is why the demand for baseball clubs will continue to rise. Not only is more money flooding in to the game, thereby increasing revenues, but heady valuations can be justified through good management. How many owners and general managers think that they are bad managers? It isn’t a hard guess. Zero!

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