The hidden value of prospects

Introduction

I have written a couple articles on prospect valuation in the past year, with my article in the 2009 annual being a good recap of everything. The prospect values I list are based on the expected performance of a prospect during his first six major league seasons. Why six? That is how long a team has control over a player before he is eligible for free agency. A team would get no additional value from a prospect if they re-signed that player for market value.

However, a trend has begun to pop up where teams are now extending their homegrown players for below market deals. Players who have done this include recently include Dustin Pedroia, Ryan Braun, Evan Longoria, Brian McCann, and many others. If top prospects are willing to sign at a steep discount, we would have to consider this value when analyzing prospect valuation.

Why players take discounts

Dustin Pedroia just won AL MVP. He is loved in all of Boston. He is a very good hitter and fielder and has all the intangibles that managers love to see. Now you may be asking yourself why Pedroia would would want to delay his free agency. He clearly would be able to receive a huge pay day when he hits the open market.

There are two main reasons why a baseball player would take a discount. One, players, and people, are generally risk averse. This means that a player in Pedroia’s situation would be willing to take a smaller, guaranteed sum of money versus a potentially larger (or smaller) sum.

Second, their is diminishing marginal utility when it comes to money earned. For example, the first million dollars a player receives makes him very happy. The second million dollars a player receives continues to make him very happy but not as happy as the first million dollars. This pattern continues and eventually there isn’t much difference when we start talking about very large sums of money.

When we put these two concepts together we can see why a player would want to take a large discount. By taking this extension, Dustin Pedroia is now set for life and a very happy man. If I were a player in the same situation, I would definitely want to receive financial security. Not only do players benefit from securing themselves, but teams obviously benefit as well.

Why teams sign players early

The main reason is that teams get a discount when they sign players early. In other words, they are paying a player a lot less than what he would make on the free agent market and sometimes even in arbitration. For example, in the link I gave earlier, Tom Tango believes Pedroia should have signed for six years and $85 million given what Pedroia would have earned in arbitration and free agency. He signed for six years and $40.5 million.

How much are those savings worth? Given my prospect valuation research, Pedroia’s savings are worth about three top 10 pitching prospects! Talk about a deal.

A team’s decision making process isn’t that easy, though. Teams also have to balance risk themselves. A lot of times these signings come when teams have only one or two seasons worth of major league data on a player. Signing the wrong player to a long term deal means that a team could have a lot of wasted money on their hands.

So teams essentially have to weigh the risk of signing a player to a long term deal and having that player regress from his expected talent versus the reward of getting a discount on a player’s contract. The fact that it has mostly been upper level players signing long term deals early may imply that teams have a pretty large risk aversion when it comes to giving long term deals to younger players. Since upper level players have such high earning potential on the free agent market, they are the only ones who can meet a team’s risk aversion and take a large enough discount. It will be interesting to see if this changes in the future.

What this means for the future

I think this trend will only continue for upper level players. Teams have been able to get pretty good discounts and it looks good towards the fan base. However, should teams be doing this?

If I were a large market team I would definitely be trying to lock up my stars long term. Large market teams have enough resources where they can handle it if one or two of these contracts don’t work out. An example of this, not necessarily with a young player, would be Julio Lugo with the Red Sox.

However, if I were a small market or middle market team, I would tend to very careful giving out long term deals. If one of these deals doesn’t go well, small and middle market teams just don’t have the resources to compensate for their mistake. For example, when the A’s signed Bobby Crosby long term, not only did they eventually have a bad contract on their hand, but they were also forced to run Crosby out their every day instead of upgrading at that position. So not only is their a potential cost of wasted money but their is an opportunity cost of not being able to sign a better player.

In conclusion, I think that teams will continue to sign upper level players to long term deals. This could thin out the free agent market and as a result it will cost more and more to sign free agents. This could result in a circular effect so that as free agent prices go up, the teams that originally sign their players to discounted deals will gain an even greater discount than what they originally signed their players for.

I also think that this gives an even greater advantage to large market teams. They can afford to take a few hits if some long term deals work out. Also, they will be more able to afford free agents at elevated prices.

Finally, prospects, in general, may see increased value if they continue to sign early at a discount. Teams may be able to keep their prospects for longer than six years at a discounted price. In the future, this is something I’m going to look at and try to factor in to prospect valuation.