Last year I started a series on the value of ball clubs. Part 1 looked at the link between payroll and valuation, while part 2 focused on whether we can trust the Forbes data, which is the only publicly available source about how much major league franchises are worth.
You may ask why, one year on, I’m revisiting this subject. Well, the original articles were supposed to be a four-part series, which I never got around to completing. The good news (or bad news if all this financial stuff bores you) is that I am ready with the third and fourth installments. Today I want to talk about how we objectively calculate the amount of lucre we’d need to pony up to buy a franchise.
Let’s dial back to the last article.
If you re-read that piece you’ll see I concluded with a quandary. Forbes is the only organization that regularly publishes ball club valuations. For undisclosed reasons it uses revenue multiples to arrive at worth. That makes sense because we can estimate revenue with some certainty; however, using revenue multiples is prone to giving wonky answers. We really need to use profit and cash flow, but that is difficult because it is hard to get accurate numbers.
Today I want to look at different approaches for valuing a baseball franchise, and then, using a robust approach with a healthy dose of assumptions, I’ll develop a semi-robust valuation. We’ll do this for the franchise for which there is the most data: the Milwaukee Brewers. This will allow us to compare our answer with Forbes’ value and also the 2004/5 sale price.
How to value a ball club
Let’s start by reviewing different valuation techniques. There are many different ways to value something but in order to not send you a sleep I’ll restrict my list to four.
3. Discount cash flow
4. Asset replacement
There is nothing complicated about comparables. In fact we use them both consciously and unconsciously every time we shop. Want a new digital camera? Go online and have a look at how much they cost. Want one with a 5x zoom rather than a 3x zoom? Well, that will cost an extra $70. How about a bigger screen? That’s $100 more. I’m sure you get the idea. By comparing the cost of cameras according to their features we begin to build a picture of what the different features are worth.
It is no different for baseball clubs. Would you ever pay more for the Royals than for the Yankees? If you answered yes may I suggest some remedial economics lessons. If we buy the Yankees we know we are paying for a team that has a massive fan base, lots of good players, a packed stadium and a barnstorming TV deal.
Okay, that was a stupid question so try take two: Would you pay more for the Pirates than for the Royals? The answer is probably that you’d pay a similar amount for each. However, suppose the Pirates had recently been sold for $200 million, then one approach would be to contrast the “features” of the Royals and Pirates and adjust the valuation accordingly.
How would this work? Well, we’d pick a couple of dimensions, say size of fan base or size of local TV market and adjust our expectation of value based on the relative difference between these dimensions. Dimensions we may consider include: media market, recent success, stadium deal, farm system, player salaries, etc.—I’m sure you can think of plenty more.
Multiples are similar to comparables but subtly different. Technically a multiple is usually applied to profit (earnings) to come up with a valuation—you have probably heard this referred to as a price/earnings multiple or P/E ratio.
The long run P/E ratio for the S&P 500 is about 16. That means for every $1 in profit for a typical company translates to a value of $16. Multiples vary for different industries. Sectors with high growth prospects tend to have higher multiples because the expectation is that the higher growth yields greater long term value. Multiples that are out of line with historic numbers are likely to be overvalued unless a structural shift has happened in the market.
Multiples are not limited to profit and can cover any financial aspect, such as revenue. Forbes uses an adjusted revenue multiple, which is combined multiple / comparison approach. Because revenue is a much poorer indicator of profit (we discuss why later) it is less reliable than a profit multiple.
3. Discount cash flow (DCF)
Adding DCF into the hat firmly puts us in the proverbial financial boxing ring. This is the tool used by any credible bank or consulting firm to value a business. Why? Because, if done correctly (and that is a big if), it is the only method that will give a true reflection of value in a rational market.
The premise of DCF is that you wouldn’t pay more for an asset than what it is worth. How much would you pay me to give you a $100 a year for the next 10 years? The answer depends on what you believe will happen to interest rates. Suppose you think they’ll stay at 5 percent the answer is $772. That is what DCF tells us.
So, how does it work? A full DCF model is very complicated but the basic premise is that we discount all future cash flows from an asset to today’s prices using a discount rate. The discount rate is based on our expectations of the interest rate and also the risk profile of the investment. The higher the discount rate the less certain we are about the sustainability of long term cash flows—in other words we think there is higher risk, so future cash flows are worth less.
To apply this to baseball all we have to do (in theory) is work out how much cash a franchise spins off now and in the future and use that to determine value. However, one criticism of DCF is that it may undervalue sport franchises. Why? As we said earlier the argument is that it is only applicable where buyers are rational and baseball owners might be many things but, as the signing of Carlos Lee attests, rational they are not.
However, this need not be a problem. Prospective owners may be irrational but they are most often businessmen and don’t like a bad deal. They may be willing to overpay but they will want to understand precisely what they are buying is worth and what premium they need to pay. If we had access to full data comparing sale prices to DCF values would be an interesting endeavor.
4. Asset replacement
We’ll talk about asset replacement value for completeness but it isn’t really applicable to baseball clubs. Asset replacement value is the amount it would cost us to replace all the assets of a franchise. This would include the players, stadium, executives and any other infrastructure. In theory it is how much it would cost us to set up the franchise from scratch.
This is irrelevant for a few of reasons. First, MLB is a monopoly so we can’t go around setting up ball clubs willy-nilly—we’d need to buy a franchise and there is a restricted supply. Second it is unclear what we’d classify as assets and how we’d value them. Are players assets? Yes, probably, but players are employees and most businesses employees don’t count as financial assets.
Third, there are ways we can increase the value of a franchise without spending (much) money or investing in assets. This distorts value. For instance, relocation to a larger media market is a sure fire way to boost the worth of an ailing franchise. The Expos are a classic example. However, now that the Capital has been snapped up there are few attractive markets left. For all practical purposes it would only be a factor if, say, the New York teams allowed another franchise to enter their market. Americans are more likely to declare Lenin a national hero than the Yankees are to make that happen.
Where to start and a word of warning
For the remainder of this column I am going to build a rudimentary DCF valuation model for the Milwaukee Brewers. Why them? If you recall from the last installment we have fairly comprehensive 10-year data for the team from 1994 to 2003, which should allow us to produce a reasonably accurate valuation for 2004. Another reason is that they were sold in early 2005 (the sale was effectively agreed in 2004) meaning that we’ll have the actual sale price to compare our valuation to.
A word of warning to all you baseball stat buffs who seek that extra decimal point in your ERA numbers: Turn away now. For here on in we need to make a raft of assumptions, some robust, others, well, flaky at best. Valuation is an art not a science and it is often amazing how accurate a model can be built with a few robust assumptions provided the sensitivities are understood. What we will use the DCF model for here is to try to justify the recent sale price of the Brewers so we can analytically refute the notion that franchises are impoverished and worthless.
Let’s get cracking.
The first part in any DCF valuation is to produce a forecast income statement for a 10-year period. This should be heavily influenced by past data and fortunately we have this going back to 1994. Here it is:
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Paid Attendance (m) 1.3 1.1 1.3 1.4 1.8 1.7 1.6 2.8 2 1.7 Operating Revenue Local baseball rev. 23.8 22.7 27.5 28.9 36.6 35.2 39.6 83.3 68.6 59.4 MLB rev. 5.8 7.3 13.8 16.3 18.4 20 20.2 21.6 25 29.4 Revenue Sharing 2.3 2.9 4 5.8 8.1 9.2 6.4 1.5 9.1 24.7 Other 1 0.9 1.4 1.8 10.3 1 1.5 3.6 1.7 2.4 TOTAL 32.9 33.8 46.7 52.8 73.4 65.4 67.7 110 104.4 115.9 Operating Expenses Compensation 22.3 17.8 23.1 27.2 39.7 47.9 41.4 52.4 55.2 48.3 Baseball Ops 10.9 12.5 12.7 13.9 15.2 17.2 22.3 22.3 23.3 26.9 Other Team Ops 11.6 10.1 11.5 12.1 12.9 13.7 12.7 16.9 19.4 20.3 MLB Expenses 2.1 1.2 1.7 2.5 1.7 2.3 3.1 4 3.4 3.6 Depreciation - 0.5 2.6 4.7 4.7 TOTAL 46.9 41.6 49 55.7 69.5 81.1 80 98.2 106 103.8 Operating Income -14 -7.8 -2.3 -2.9 3.9 -15.7 -12.3 11.8 -1.6 12.1 Extraordinary Items -1.8 -4.2 -6 -5.8 -6.1 -6.3 -6.2 -6.3 -9.2 -7.6 Net Interest Income - - - - - -0.3 20.5 1.2 41.2 -2.3 Net non op. inc. -1.8 -4.2 -6 -5.8 -6.1 -6.6 14.3 -5.1 32 -9.9 NET INCOME -15.8 -12 -8.3 -8.7 -2.2 -22.3 2 6.7 30.4 2.2
One important distinction to make is that in 2001 the Brewers moved to Miller Park, which, as you can see from the data, led to a spectacular jump in revenue. This goes to show the effect that a new stadium can have on club revenue.
We’ll quantify this more precisely next week but factors include: increase in attendance, better and more expensive concessions and higher ticket prices, to name three. What is more if stadium has been financed by public money the franchise doesn’t need to directly pick up the tab (though in some cases the club is obliged to share a portion of revenue with the state—it all depends on the stadium agreement).
Show me the flaky assumptions
We could generate reams of assumptions to try to precisely piece together a 10-year forecast income statement but there are plenty of good reasons not to do that. First, you’ll fall asleep. Second, you’d have to wait another two months for me to find the time to get all the data, double check all the assumptions and publish the article. Third, a simple model will, nine times out of 10, give as good a (if not a better) result as a complex model. Anyway, with no more ado here are the revenue assumptions.
Local baseball revenue: This relates to all revenue generated in a ball clubs locality and ranges from sale of tickets and in-game concessions to stadium sponsorship and local TV money. It excludes national TV money and team merchandise sold outside of the stadium; both of these go into another revenue pot.
We see that with the opening of Miller Park attendance climbed to 2.8 million but by 2003 attendance had slipped back to 1.7 million. Let’s assume that the Brewers put 100,000 more bums on seats each year through better marketing and increased popularity of baseball. Looking at 2006 attendance, which was 2.3 million, this assumption is conservative — the beauty of hindsight—but in 2003 people probably would have thought you were Henry Blodget. Average 2003 ticket prices were $16.86. Estimating parking and other concessions at $12 per fan gives total fan revenue of $28.86. Assume that both these grow slightly ahead of inflation at, say, 5 percent, which is in-line with how ticket and concession prices have generally risen in the past.
The remaining local revenue is from local broadcasting, advertising and sponsorship. In 2003 the local TV deal was worth about $6 million, leaving another $5 million for advertising and sponsorship, so the numbers seem to make sense. General inflation in baseball has historically been about 10 percent. TV contracts have driven this, but let’s be conservative and plump for 8 percent, which is in-line with the 2002 to 2003 increase in local broadcast revenues. An expectation in improved economic conditions would also support a slightly higher increase and gives us confidence that our assumptions are safe.
Postseason revenue: Face it, the Brewers are a small market team and play in tough division. OK, so in 2008 the division seems wide open but back in 2003 no-one could see a way past the mighty Cardinals. Assuming revenue from a playoff appearance would be folly, so let’s not bother.
MLB Revenue: This relates to the national TV contract and internet revenues from MLBAM. Although MLBAM is a roaring success today and MLB has recently negotiated a lucrative TV deal, in 2003 that may not have been clear. Let’s assume that this revenue increases in line with the historic five-year growth rate, which happens to be 11 percent.
Revenue sharing: This is a tricky beast; to calculate it we need to weigh up a number of different revenue components not only for the Brewers but all of baseball. There are three components to revenue sharing outlined in the 2002 CBA:
- 34 percent of local revenue goes in to the pot, divided equally. This is called Base Plan
- Central fund where richer clubs give cash to poorer clubs based on the last three years of revenue sharing. The idea is that at full implementation the central fund will equal 41 percent of the Base Plan. The central fund component ramps up at 60 percent in 2003, 80 percent in 2004 and 100 percent in 2005 and 2006
- A small discretionary fund for the commissioner to distribute as he sees fit
In addition to this there tends to be a number of other adjustments that affect how much cash each team sees. Also, remember we are sitting here in 2004. The then-CBA had another three years to run before renegotiation. What would happen at that point would be anyone’s guess.
What should we do? There are a number of options but the safest course is to look at 2001-2003 revenue sharing and extrapolate that. After all we know that the revenue sharing that the Brewers receive is tied to overall MLB revenue. There is nothing to suggest that the ratio of MLB to Brewers revenue will change much in the future. The only adjustment we need to make is for the ramp up of the Central fund.
We know from the financial notes that the revenue sharing number was inflated by $8.4 million in 2003 because a payment due in 2001 was deferred. That makes actual 2003 revenue sharing $16.3 million. The big jump from 2002 was because the central fund component kicked in. It is difficult to infer much from historic trends because the revenue-sharing line has jumped all over the place.
Our assumption will be to assume that growth in revenue sharing is such that once the full allocation from the central fund has kicked in the ratio of money from revenue sharing to total revenue remains the same. This translates to a 6.5 percent CAGR.
That means that revenue sharing drops to $19 million in 2004 and then rises to $38 million by 2013.
Other: This is non-baseball revenue and has averaged $3 million between 1994 and 2003. Let’s assume this recurs to 2014.
Now on to expenses:
Compensation: This category includes salary and ancillary benefits. Wage inflation was 9.5 percent for MLB between 1994 and 2003 but the Brewers expanded payroll by a more conservative 8.8 percent, though with a huge hike in the 1999 season. We’ll assume payroll growth of 8.9 percent, which is in line with the Brewers’ historic rate, although.
Note that if we were doing a complete analysis we’d look at individual player contracts over the coming years and factor in those increases. However, for the purposes of this exercise it is OK to assume that the Brewers will trade their way out of any huge salary obligations as they have done in the past. There is nothing to suggest a huge hike in payroll is expected.
Baseball operations: This includes scouting, player development and baseball administration. After the opening on Miller Park, the Brewers increased spending in player development and scouting. In 2003 they ranked ninth in the league. Let’s assume they keep this up—after all, it should keep a lid on salaries in the long term—and that costs rise slightly ahead of inflation at 5 percent.
Other team operations: This largely relates to the expense of operating Miller Park, hence the jump in 2001. There are a number of one-off reasons given such as changes to management, doubling in stadium operating expenditure, increased pension liabilities and host of other minor items. The best assumption we can make is that this has stabilized so will increase slightly ahead of inflation at 5 percent a year.
Other expenses: Assume that MLB expenses increase at 5 percent and that depreciation stays at $4.7 million until the stadium debt of $90 million is covered.
Phew. If you have gotten this far I’m impressed. Hang on in there we are almost done. This is what out forecast income statement looks like (note: we can ignore non-operating expenses as these do not affect cash flow, which is what is needed for the valuation):
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Paid Attendance (m) 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 Operating Revenue Local baseball rev. 65.6 72.3 79.5 87.2 95.5 104.5 114.1 124.4 135.4 147.3 MLB rev. 32.4 32.4 32.4 32.4 32.4 32.4 32.4 32.4 32.4 32.4 Revenue Sharing 19.7 23.5 25.0 26.6 28.4 30.2 32.2 34.3 36.5 38.9 Other 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 TOTAL 120.7 131.2 139.9 149.2 159.3 170.1 181.6 194.0 207.3 221.5 Operating Expenses Compensation 52.5 57.1 62.0 67.4 73.3 79.7 86.6 94.1 102.3 111.2 Baseball Ops 28.2 29.7 31.1 32.7 34.3 36.0 37.9 39.7 41.7 43.8 Other Team Ops 21.3 22.4 23.5 24.7 25.9 27.2 28.6 30.0 31.5 33.1 MLB Expenses 3.8 4.0 4.2 4.4 4.6 4.8 5.1 5.3 5.6 5.9 Depreciation 4.7 4.7 4.7 4.7 4.7 4.7 4.7 4.7 4.7 4.7 TOTAL 110.5 117.8 125.5 133.9 142.8 152.5 162.8 173.9 185.8 198.7 OP. INCOME 10.1 13.4 14.3 15.4 16.4 17.6 18.8 20.1 21.5 22.8
Operating margin is 5 percent in 2004, rising to a long run average of 11 percent by 2006. A margin of 11 percent for a monopoly business, albeit one with some very high fixed costs, sounds a tad conservative, if anything. Although many of the assumptions can be debated and probably refined with a little more time, we can logically justify all of them. This exercise shows that outside of controlling payroll, profit is largely determined by revenue generation, which certainly gives a little more comfort to Forbes’ methodology.
We need to speed along and turn this income statement into a cash flow. The quickest way to do this is to add non cash items (depreciation in this case) to profit.
There are two more parameters we need to generate a value. First is the long term growth rate for the Brewers’ revenue and profit, and second, the discount rate with which we discount all future cash flows to today’s money. A long-term growth rate of 10 percent across the board fits with what we have observed over the last 20 years in baseball, so let’s go with that.
The discount rate is slightly trickier though. The most stable companies will have a discount rate of 7-10 percent—3-4 percent because of underlying interest rates/inflation and 4-7 percent due to risk. However, baseball is far from a normal business as it operates as an effective monopoly. This reduces risk substantially. This lower risk factor is offset by higher baseball cost inflation, which has been running at about 7 percent. Assuming a risk premium of 3 percent we get an overall discount rate of 10 percent.
Using a bit of financial black magic we can construct a cash flow statement and a valuation. (Note: Free cash flow = operating income + depreciation; terminal value is the remaining value into perpetuity and was calculated by taking 2013 free cash flow and dividing by the perpetuity growth rate [10 percent]; final cash flow just adds the terminal value to the 2013 cash so we can compute the total value):
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Free cash flow 14.8 18.1 19.0 20.1 21.1 22.3 23.5 24.8 26.2 27.5 Perpetuity rate 0.1 Terminal value 275.4 Final cash flow 14.8 18.1 19.0 20.1 21.1 22.3 23.5 24.8 26.2 303.0 Discount rate 0.1 VALUE $233.7 m
Hey presto. We get a value of $234 million. So how does this compare with the Brewers’ sale price in 2004 and the Forbes valuation?
$ m Forbes 208 Purchase 223 THT 234
Bang on (more or less). OK, I hear the critics among you who cite the odd flaky assumption. You probably won’t believe me when I tell you that these assumptions were straight off the bat and not reverse engineered to fit the sale price! The point is that with just a few small tidbits of information we can build a semi-robust model to value a ball club and get darn close to the real value.
Mark Attansio, the new owner of the Brewers, is an investment banker. His DCF model for the Brewers’ would have been just a slightly more detailed version than mine.
What about the sensitivities?
In any business a significant up tick in cost or a slump in revenue can have a disastrous impact on valuation. In essence every $1 million we lose in profit, we lose $14 million in value! Think about it for a minute. If we increase payroll by an extra $5 million in 2004 by signing a free agent then that free agent better generate at least $5 million in revenue (through either increased attendance, merchandising, or be the difference in getting the team to the post season) otherwise he will destroy value. $5 million for a free agent gets you a pretty average player, so in all likelihood additional revenue generated would be zilch. In all our valuation is cut by a whopping $70 million.
That was fun, right? I hope so. In the final installment I’ll talk about what leeway executives have to manage the value of their franchises. Where should they be focusing their attention and what are the impacts of these decisions. And given my track record with this series, I’ll try to do that before 2009!
References & Resources
Thanks to Forbes for publishing values and for the local goverment of Milwaukee who thought it would be a good idea to build a rudimentary income statement that we were able to use.