## Tuesday, September 01, 2009

### Re-estimating an NHL team's Picasso value

Sports franchises are different from "regular" businesses in one important way -- they're a lot more fun. If you own a team, you get any profit it makes, but you get lots of perks in addition to that. You get to be on TV a lot. You get the best seat in the house. You get to hire and fire staff. You get quoted in the paper any time you want. You get to be a hero in your local community. And so on.

Because of this, you'd expect team owners to be willing to pay more for a team than its future earnings are worth; they want the "consumption value" in addition to the investment value. You can call this the "Picasso effect," because owning an expensive sports team is a bit like owning an expensive painting; you do it partly for the pride of ownership.

In the previous post, I tried to estimate the Picasso value this way: I ran a regression to predict team market value from team earnings (both values as estimated by Forbes). The equation came out

Market Value = 4 * annual earnings + \$200 million

From that, I suggested that Picasso value was \$200 million: that is, since the \$200MM term didn't have anything to do with the success of the business, it must be the value that owners are willing to pay just to own the team.

But, following a post by Dackle over at "The Book" blog, I realized that isn't quite right.

The problem is that team value -- at least that portion that has to do with earnings -- is based on *future* prospects. And future prospects don't correlate 100% with current prospects. In effect, some of today's earnings is random noise -- the economy might be good in that particular city, or a promotion works well, or the team is just having a good year.

The more random noise, the higher the Picasso estimate. For instance, suppose that profits were completely random, and had nothing to do with any particular attribute of the team. Then, all teams would be valued equally, and the equation would be

Market Value = 0 * annual earnings + \$220 million

And it would look like the entire value was Picasso, when, in reality, it could be that the value is driven entirely by earnings.

So to do the calculation right, you have to remove the noise from the earnings.

To try to figure out how to do that, I started by running a regression on Forbes 2008 earnings vs. 2007 earnings. If earnings were completely random, the correlation coefficient would be zero. Of course, it wasn't zero; the Leafs were profitable not because they were lucky that year, but because there are millions of loyal idiots like me who worship the team even though it continues to suck. The correlation coefficient was actually a very high .93. I'll put that in courier font:

One-year earnings correlation coefficient = .93

An r of .93 doesn't suggest a lot of noise, so it won't change things much. But maybe the .93 is still too high. Remember, the economic value of the team is the present value of *all* future earnings, not just next year. And earnings might change more in future years. For instance, between one year and the next, team performance is usually similar. Good teams stay good teams, and poor teams stay poor teams. Maybe that all evens out after, say, five years.

If we take .93 to the fifth power, in effect "compounding" the regression to the mean, we get about .70. This seems reasonably generous to me; a correlation of .7 is an r-squared of .5, which implies that the "fixed" component of a team's earnings has the same variance as the "variable" component.

That means that to get a team's "true" earnings from its 2008 earnings, we regress the number 30% towards the mean. To take one example: the Rangers had earnings of \$30.7MM in 2008. The mean is \$4.7MM. Regressing \$30.7MM thirty percent towards \$4.7MM gives \$22.9 MM. So we assume that the expected value of the Rangers' "real" earnings was \$22.9MM, and the remaining \$7.8MM was due to random factors specific to that season.

If we do that for all 30 teams, and rerun the analysis using our regressed estimates of earnings, we now get

Market Value = 5.6 * annual earnings + \$193 million

Not much different ... but better, I think. I'm more comfortable with a higher earnings multiple (5.6, in this case, rather than 4.0), since, for publicly traded securities, ratios (I think) tend to range between 7 and 11.

So this reduces our estimate of "Picasso value" from \$200 million to \$193 million. Not much. And it's easy to see why not much: according to the Forbes data, the money-losing teams are worth an average of about \$160 million. If you believe these teams will continue to lose money, then, obviously, the Picasso value must be at least \$160MM, since they're worth zero as a going concern.

I believe some of the \$193 million is Picasso value, and some of it is hopes that the team will eventually be profitable: either by moving it to a city where it can make money, or by making more money in other ways (like a better TV deal).

Anyway, getting back to the Zimbalist/Balsillie question of how much more a team is worth in Hamilton ... if we run the revised numbers, we get an even bigger difference -- which makes sense, since the more profits matter, the more a team is worth in a money-making city as compared to a money-losing city.

The regressed estimate for Phoenix earnings is a loss of \$5.4MM. For Hamilton, we continue to use Balsillie's own estimate of \$11MM (we don't regress that since it's an estimate and not an actual observation).

That means, by this method,

\$163MM market value for Phoenix
\$255MM market value for Hamilton

Still, about the same as in the previous analysis. The benefit to the move is around \$90MM, and three-quarters of the value of the Hamilton franchise is Picasso value.

(Thanks again to Dackle for the comment that led to this post.)

Labels: , , ,

At Wednesday, September 02, 2009 7:00:00 PM,  Dackle said...

I suppose in this situation I would lean toward the revenue-based regression rather than operating income. The argument would be that a team with \$X of revenue, average management and average success on the ice should be able to earn an industry-average net margin, and so the resulting earnings number would be a bit more stable.

I just can't help but think that the \$200m is either measurement error, or it's part of the formula Forbes uses to estimate market value. The higher revenue-based correlation doesn't have the same intercept, at least to the same degree. If you think of market value as "runs", and earnings as "home runs" (well, probably more like hits or total bases), then a regression on current AL batting stats shows runs/game = 1.67 (HR) + 2.91. From that, you might conclude that there is a value of 2.91 runs/game just by stepping on the field, but we know that the 2.91 is just standing in for what we can't measure.

Of course, the big counterargument is that the \$200m you found is also standing in for what can't be measured, and that thing could very well be the Picasso effect.

The other thing to consider is that the Minnesota Wild broke even last year and are worth \$217m. You could incorporate your local hockey team and also break even, but it wouldn't be worth \$217m. So maybe the \$200m is NHL franchise value, or the value of being part of the NHL infrastructure (ie it sends the Leafs and Rangers to play games in your arena).

At Wednesday, September 02, 2009 7:14:00 PM,  Phil Birnbaum said...

Dackle,

The problem is, when the average market value is \$220MM but the average earnings are only 4.7MM, it's hard to make the case that a team should be able to make a profit with average revenues and average luck. That's still an enterprise multiple of ... 40!

No matter how you slice it, the only way it makes sense is if a large chunk of market value is SOMETHING other than current revenue/earnings. I think most of it is Picasso, but it could be something else. Rodney Fort thinks a large chunk is intangibles that translate to money (like cross-marketing opportunities that don't show up in revenue), which sounds plausible to me.

I guess we agree, that the \$200 MM is *something*. And it's huge: almost 90% of market value.

And I'd bet that if you took a bunch of different businesses in the same industry, you'd get a multiple that made more sense, and a constant term far, far less than 90% of market cap.

At Thursday, September 03, 2009 10:23:00 AM,  Rodney fort said...

Hi Phil.

As per my comment on the immediately previous post.

Your estimates will surely confuse "Picasso Value" with other values of ownership that are not captured by the team's own bottom line (the folks at Forbes make the same mistake).

At Thursday, September 03, 2009 10:29:00 AM,  Phil Birnbaum said...

Rodney: yup, I agree, as I mentioned in the comment immediately preceding yours.

Previously, you mentioned a figure of 30% of market value for those other factors. Do you think the rest is Picasso value? What do you (or other economists) think the Picasso value is, even very roughly?

At Friday, September 04, 2009 11:07:00 AM,  Rodney Fort said...

I won't speak for others. But for me, unlike Andy, I am reluctant to got there at all. Teams are not "collector items" in the same sense as a painting so that logic is a stretch.

And that type of market depends only on keeping the items rare and the willingness of others to put value in the "asset;" if one is thinking about resale then paintings are just like baseball cards. And just as precarious an investment.

Sports teams have a true fundamental value like any firm --the ability to generate a predictable flow of profit. That should be the value of the asset.

It's just that sports teams can generate some types of profit that are not captured just in the team's bottom line.

So... my reply is, awaiting any work at all that actually pegs the consumption value of ownership, ALL of the value is value of the asset in generating profits.

If one suspects some owners are not concerned with the underlying fundamental value, then one should turn not to a modified finance estimation, but to utility maximization. The owners in these particular cases are just fans with really big pocketbooks and modeling them as utility maximizers will gain you more analytical leverage over their actions.

At Thursday, September 10, 2009 9:55:00 AM,  dq said...

You really would only see a regression on a team operating below average; someone buying a business will analyze that company and make assumptions on what their cost structure and revenues will be. Most likely they will project that they will run the business/have less costs better than the existing owners. If the average team earns \$20 million a year, the \$30 million a year team will project future earnings pretty close to that number. The team earning \$10 million will try and figure out how they can increase their earnings - most likely they will project a number closer to \$20 million. So your regression might be .90 for teams over the average and .30 for teams under the average - just making up the numbers.

At Friday, September 25, 2009 3:44:00 AM,  Unknown said...

I think 5.8 times annual earnings is far too low. Most publicly traded companies are not valued at 7-11 times earnings. The historical average for the S&P 500 is around 15. Until very recently, it was far higher.

http://www.barelkarsan.com/2008/06/s-500-historical-pe-vs-todays-pe.html

Privately traded firms typically have lower multiples in valuations, but that is mainly based on size. Its assumed that the small business owner is putting in hours and not fully compensating himself in salary. Hence the company earnings are higher and the multiple lower.

If a company is worth hundreds of millions, it should be valued as if it was a public company. There are all sorts of variables involved here, but 20 would be a reasonable P/E average. P/Es above 40 are not at all rare. I wouldn't buy a company that high, but others certainly would.

You have the Picasso value staying stable across cities. I'm not sure if thats true. I think a large part of the Picasso value comes from being a local bigshot. Owners like to be recognized. They get good tables at restaurants etc. I think the NHL owner would be a much bigger big shot in Hamilton than he'd be in Phoenix. I'm not sure that many people in Phoenix care about sports and hockey is a distant fourth. In Hamilton, he'd be the most powerful man in town.

I also think cross marketing is extremely important. This is also where the "big shot" element has a practical purpose. The owner would probably have a leg up in his other business' contract negotiations if he could invite CEOs to the owner's box.