More on "psychic value"

In Malcolm Gladwell's piece on the "psychic value" or "Picasso value" of owning a sports team (which I talked about here), there was a reference to an academic study (.pdf) that tried to find the psychic value of owning a painting. That study found that psychic value to be around 28% of the value of the painting.

Well, that makes no sense. Paintings don't return a stream of income (unless you charge admission to see them, which isn't the case here). The only benefit to owning the painting is the intrinsic, subjective value you get from owning it. So the "psychic value" of owning the painting can't be 28% of its value. It must be 100%.

The confusion, I think, comes from the fact that, sometimes, you can sell a painting at a profit. That makes it seem like there are two benefits to the painting -- the psychic benefit of ownership, and the potential capital gain at the end. But, really, there's one benefit: the psychic one. Sure, the *value* of that psychic benefit will likely rise over the years, and, when it does, you can sell that benefit to another buyer at a higher price. But you're still selling only joy.

The "profit" is actually something you can expect, and it's built into the price of the painting. Suppose owning a Picasso is worth $100K a year in "psychic value" to the person who likes it best. And that value rises every year by the rate of inflation -- say, 5%. And suppose interest rates are 10%.

The buyer then expects:

$100,000 worth of psychic value the first year
$105,000 worth of psychic value the second year
$110,250 the third year
$115,763 the fourth year
... and so on.

How much is he willing to pay for the painting? Well, at a discount rate of 10%, it works out to $2 million. By buying the painting for $2 million, the buyer forgoes $200,000 in interest that he would get otherwise. In exchange, he gets $100,000 in psychic value the first year, and the painting appreciates by $100,000.

But if you were to look at the fact that the psychic value equals the appreciation, and conclude that only 50% of the value of the painting was psychic value, you'd would be incorrect. Psychic value accounts for 100% of the value of the painting. The appreciation comes from an increase, over time, in the rate of return in psychic value.

What you CAN say is that, of the first year's forgone interest on the value of the painting, 50% of that represents the psychic value consumed that year, while 50% represents appreciation of the remainder of the psychic value. But that's not that brilliant an insight. It's true for everything you buy: the "psychic value" must be at least the forgone interest minus the appreciation (or plus the depreciation, which is negative appreciation). If you buy a TV for $1000 at 10% interest, and it loses 20% of its value every year, the first year's "psychic value" must be at least $300, or you wouldn't buy it.

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Another thing that's confusing is that sometimes paintings appreciate a lot more than inflation, which makes them look like a good investment. But that's got to be random. If it was known in advance that the painting would appreciate more than stocks, the price would go up immediately as buyers bid up the price. Those stories you hear about buyers paying $500 and selling for $1,000,000 ... well, those are outliers, like winning lottery tickets. In a reasonably efficient market, the sum of the psychic value, and the appreciation, must be close to the return you can get from other (similarly risky) investments.

But life is random, and it's possible that values increased much more than expected in the past. The art world may have thought that psychic value would increase only with inflation, but, as more and more billionaires were created, the psychic value rose even faster. That would certainly have caused prices to rise faster than expected, and would make paintings look like a good "investment". But the market would adjust to the new expectations. Indeed, as it did, prices would rise even faster! They'd rise once for the fact that psychic values are now higher, and they'd rise again for the fact that psychic values are accelerating over time.

In retrospect, that may have made paintings look like they were a better than average investment (which I guess they would have been). But that's not because paintings have two benefits -- psychic, and non-psychic. It's because they have one benefit, psychic, and the value of that benefit increased sharply. If you buy a painting as an "investment," you are speculating in the value of its psychic benefits. And you are betting against the market. Unless you have much, much better speculative skills than anyone else, you're probably going to break even in the long run, before taking into account auction fees, and such. And "breaking even" includes psychic benefits. If you don't like art, the expectation for your overall experience is strongly negative, compared to other investments.

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Another way to look at it: suppose you hate paintings, and the fame that comes with owning them. You buy a Picasso for a million dollars as an investment, but laws are passed that prevent you from ever, ever selling it or renting it. Now, the value of the Picasso to you is zero. You might as well have never bought it. You have a loss of a million dollars, as if you spent your money on a big bag of manure.

Now, suppose you instead buy a million dollars worth of McDonald's stock. And, again, suppose you are prevented from ever selling it. You won't care that much. Because, McDonald's is going to keep making profits, and sending you ever-increasing dividend checks every quarter. The present value of all those dividend checks works out to a million dollars.

When you buy a painting, you're buying a stream of quarterly "dividend checks" of 100% psychic value. When you buy a stock, you're buying a stream of quarterly dividend checks in 100% cash.

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Now, a sports team is a combination of a Picasso and a McDonald's. It produces psychic benefits, but it also produces profit (perhaps negative profit). So, *now*, it's a real question to ask what percentage of a sports team's value is psychic value, and what percentage is investment value. The answers are no longer 100% and 0%, like they were for a painting.

But it depends on the team. For a big-market profitable team, the investment value might be 70% or more, and the Picasso value 30% or less. For a team that loses money, the Picasso value might be greater than 150% or 200% of the total value.

But, again, that percentage doesn't mean much in the real world. What matters the ratio of annual Picasso value to cash losses. Because, if that goes over 100%, it means the owner is losing more money than he's prepared to lose. It means the owner is not bluffing when he says he's bleeding too much money.

If an NBA team loses $25 million, is that a problem big enough that the players should have to take a pay cut? It depends. If the owner's Picasso value is more than $25 million, then the players can say, "no way". If the Picasso value is less than $25 million, the players need to at least consider that the owners are in a financial situation that they don't consider sustainable.

Because, suppose nobody in the world is willing to pay more than $25 million a year for the thrill of owning a team. And suppose that team is perpetually losing $30 million a year. Then, the team becomes, literally, valueless. It becomes in the owner's interest to fold the team entirely. It is in the interests of the players to figure out if NBA teams are approaching that point, and, if so, what should be done about it.

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.)

Is a Hamilton NHL team worth as little as Andrew Zimbalist thinks?

I've just finished reading Andrew Zimbalist's sworn submission to the courts with regard to the Phoenix Coyotes situation (hat tip to blogger James Mirtle for posting the entire legal document), and there's lots in it I don't agree with. It could be that I don't understand the antitrust or economics issues, which, of course, are Zimbalist's specialties. I'll list my issues and maybe someone can explain.

First, a quick summary of the situation, as I understand it.

The Phoenix Coyotes are bankrupt. Jim Balsillie wants to buy the team and move it to Hamilton, Ontario, a hockey-mad city 45 miles from Toronto. The NHL doesn't like the idea. First, it believes that it, not the courts, have the right to decide where a team plays. Second, it seems to want to protect the Toronto Maple Leafs from competition. And, third, it doesn't like Balsillie, who is being combative with the NHL rather than cooperating with it.

Zimbalist's written testimony, written at the request of the Balsillie team, argues that

(a) a franchise in Hamilton is worth only $12 million more than if the bankrupt franchise was left in Phoenix, at $175 million versus $163 million;

(b) the effect on the Toronto Maple Leafs would be minimal;

(c) the price Balsillie is offering to pay for the team, $212 million is therefore more than the team is worth, and the difference is "Picasso value," the price Balsillie is willing to pay for the consumption pleasure of owning the team;

(d) the Hamilton expansion opportunity does not "belong" to the NHL.

Maybe there's something about the economics I don't understand, but I don't see it the same way. I'll deal with (b) and (d) in a future post, but for now, let me concentrate on (a) and (c). I think the team is worth substantially more than $175 million, and I think the "Picasso value" is huge, much more than the $37 million that Zimbalist thinks it is.

First, doesn't it seem strange that a hockey team in Hamilton, so close to the best hockey market in the world, would be worth only 7 percent more than the same, bankrupt team in a non-hockey market in the desert? The way Zimbalist gets his numbers is to multiply gross revenue by 2.4. That's based on Forbes Magazine's estimates of team revenue and market value (Zimbalist doesn't justify the 2.4 figure separately).

That seems strange to me, valuing a team by its revenues rather than its profits. It would kind of make sense in comparing "normal" businesses, companies of different sizes in the same industry. Suppose you have two widget manufacturers; Acme sells $10 million worth of widgets a year, and Consolidated sells $100 million worth. You'd expect Consolidated to be worth about 10 times as much as Acme. After all, Consolidated probably has 10 times as many employees, and 10 times as many machines, and 10 times the bill for raw materials, and 10 times the shipping costs, and so on. All else being equal, Consolidated should make 10 times the profit.

But that's not the case in the NHL. With the salary cap, you could argue that team expenses are roughly the same, whether the team is in Glendale or Hamilton. Most of the expense is salaries, and those are now fixed in the range of $41 to $57 million. Forbes has the Coyotes at revenue of $68 million, meaning that if they paid $50 in player salaries, that would leave only $18 million for other expenses and profit. On the other hand, a team like Vancouver, with $107 million in revenue, has $57 million left for other expenses and profit.

For both teams, it looks like those "other expenses" are around $30 million: because Forbes has Vancouver turning a profit of $19 million, whereas Phoenix *lost* $10 million. Vancouver is a profitable enterprise, whereas Phoenix would struggle just to break even. Profits are much less proportional to revenues in hockey than they are in a "regular" business. So why use revenues as your measure?

As a verification, I ran a regression to predict team value based on revenues. The results:

Market Value = 3.2 * annual revenue - $73 million

or, rephrased,

Market Value = 3.2 * (annual revenue - $22.8 million)

The correlation coefficient was .965.

So the value of a team isn't a multiple of revenues: it's a multiple of revenues *above $22.8 million*. Suppose the Coyotes make $68 million revenue, and the Hamiltons twice that. Hamilton won't be worth twice Phoenix, then: it'll be worth two-and-a-half times. Apparently you need at least $22.8 million in revenue to make the team desirable even at $0. Only revenue after that translates into market value.

If you look at Forbes' chart, you can see that: the top 6 teams have a little less than twice the revenues of the Coyotes: and they're worth a little less than 250% as much.

Anyway, if you use this formula for the Coyotes instead of just 2.4 times revenue, you get $145 million, not $163 million. That makes sense, since the regression was based on Forbes data, which values the Coyotes at $142 million. However, Zimbalist did consider subsidies from the city of Glendale, which might make up part of the difference.

As for Zimbalist's Hamilton estimate ... well, he takes Balsillie's own estimate, which assumes revenues would be $73 million. That, to me, seems *way* too low. It would put Hamilton last among the other Canadian teams:

$160MM Leafs
$139MM Habs
$107MM Canucks
$ 96MM Senators
$ 97MM Flames
$ 85MM Oilers

I think an estimate of $100 million would be much more appropriate, given the size of the market. Based on the results of the regression, that would make the new Hamilton franchise worth $247 million -- not $175 million.


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Now, Zimbalist also calculates team value another way, a better way: by estimating actual future profits, and calculating their present value. He doesn't do that for Phoenix, which I think is because he can't predict the Coyotes to ever make a profit in the future (in which case, shouldn't its value by this method be zero? But I digress). However, he does it for the proposed Hamilton franchise. Here's how: he starts with Balsillie's own projections of earnings the first five years of the franchise. Then, he assumes earnings will grow steadily for the next 25 years. He then discounts all 30 years' profit into today's dollars.

Zimbalist performs this calculation for five different 25-year growth rates (from 3 to 7 percent) and for three different discount rates (from 8 to 12 percent). He winds up with a franchise value ranging from $70 million to $177 million, with a typical value of $150 million.

This is all quite reasonable, although you have to keep in mind that Balsillie is probably being very conservative in his earnings projections in order to keep his price down. Still, it doesn't seem like this is how other teams are valued, probably because of the "Picasso factor." Looking at the Forbes chart, the market value of teams is much, much flatter than their earnings. The top three teams (Leafs, Rangers, Habs) make an average of about $45 million a year, and their market value is about $400 million -- an earnings/price ratio of about 11%. But the teams in the middle, who look like they make an average of about $3 million a year, are worth about $200 million -- an earnings/price ratio of about 1.5%. And the teams at the bottom are all losing money -- but their market values are still around $160 million.

Why are the values so flat relative to profits, where a team that makes $1 million a year is worth almost half as much as a team that makes $40 million a year? It could be the Picasso effect. I ran a regression to predict market value based on earnings. The results, rounded:

Market value = $200 million + 4 times annual earnings

The correlation coefficient? 0.88. Not as high as for revenues, but still huge.

What that tells us is that, regardless of earnings, there's a value of $200 million dollars to owning a team, even if it only breaks even every year. That might be Picasso value. Or, it might partially reflect the value of the right to move the team if it starts losing money. It might reflect the fact that owners think that earnings will jump soon -- maybe they think a new TV contract will someday be worth a present value of $30 million each, and that's part of the $200 million. But I think it's consumption value, Picasso value.

$200 million does seem reasonable in terms of consumption value. At today's low interest rates of (say) 4%, the opportunity cost of locking up $200 million is only $8 million. Most of these owners are billionnaires -- what's a tiny $8 million a year? Jim Balsillie's own willingness to pay is no doubt much more than $8 million. He likes publicity. He's making much of the fact that he wants to bring the NHL to more Canadian cities, making him something of a hero in some circles. He might have some ambitions beyond NHL owner, ambitions which being in the limelight will further.

Using the regression results puts the Coyotes at $161 million, which is about where Zimbalist has them in his revenue model (he can't use the earnings model because the Coyotes have negative earnings).

So, let's say we use this same regression equation to value the Hamilton team. Balsillie claims that five years from now, the team will be making $11 million. That means it'll be worth about $244 million then. Discounting that to today's dollars, at 4%, gives $209 million today. Adding in $35 million of Picasso value ($40 million discounted) for the next five years takes us back to $244 million.

And, again, that's conservative because it uses Balsillie's own estimates of his profits. Here are the earnings of the six Canadian teams last year, according to Forbes:

$66.4 million (Leafs)
$39.6 million (Canadiens)
$19.2 million (Canucks)
$ 4.7 million (Senators)
$ 7.4 million (Flames)
$11.8 million (Oilers)

Judging by this, I'd say that, for a Hamilton franchise, $11 million five years from now is pretty conservative. Even so, the Picasso value drives so much of franchise valuation that it doesn't matter much: even if the Hamiltons made as much as the Canucks, it would only raise the franchise value from $244 million to $276 million.

So I think the team in Hamilton is worth about $250 million. Not only is this substantially higher than its worth in Phoenix, but it's even more than Balsillie has offered. So I bet Balsillie is willing to spend a whole lot more than his $212 million offer, if necessary, to achieve his dream of a team in Hamilton.

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So, a summary of our respective market value estimates:

Zimbalist thinks:

-- Phoenix $163MM by revenues
-- Hamilton $175MM by revenues (based on $78MM in revenues)
-- Hamilton $150MM by earnings

I think:

-- Phoenix $145MM by revenues, plus government subsidies
-- Phoenix $161MM by earnings
-- Hamilton $247MM by revenues (based on $100MM in revenues)
-- Hamilton $250MM by earnings

Zimbalist thinks the difference between Phoenix and Hamilton is maybe $12 million at most. I think the difference is close to $100 million.

Am I missing something?

Forbes NFL team values and the Picasso theory

Forbes has just released its annual listing of NFL team values, revenues, and earnings. The Dallas Cowboys “are now the single most valuable sports franchise on the planet,” at $1.5 billion. The average NFL team is worth over $950 million.

Just as for the NHL, the value of football teams is highly inflated given the amount of earnings. The mean team operating income in the NFL is $17.8 million, which is only a 1.85% return on the $950 million average market value. Put another way, the “enterprise value ratio” of the average team is over 50 (950 divided by 17.8). Typically, publicly traded businesses are around 10.

I argue that teams are inflated because they are toys for the rich. If that’s the case, we can figure out how much those toys are worth. If the team owner invested his $950 million in an investment earning, say, 8%, he would have made about $76 million. Instead, he made only $17.8 million. So rich old football fans are willing to spend $56 million a year to own a team.

In hockey and baseball, though, the figures are much lower. NHL teams earn 2.3%, and so the cost of ownership is 5.7% of their $180MM value. That’s only $10 million. In baseball, the average team (I eyeballed the chart) seems like it’s worth about $400 million, and earns $16.5 million. That means the cost of ownership is $15.5 million a year.

My theory, that sports teams are like Picassos – owned for the pleasure of ownership – suggests that the cost of NFL and MLB teams should be closer than they are. You can own an MLB or NHL team for less than a third the annual cost of owning an NFL team. Why should that be so? Are NFL teams so much more fun to own? Is there really so much more demand that prices should be three times as high?

Another theory, from David Gassko (see comments), is that owners know they will eventually be able to sell teams at a hefty profit, and so don’t care so much about operating earnings. But that still doesn’t explain why NFL teams should be worth so much more, does it?

NASCAR teams worth less than other sports teams

Forbes has estimated the values of NASCAR teams. They run cheaper than in other sports, averaging about 10x operating income. The NHL averages around 43, for instance.

I suspect they're cheaper because they're not as much fun to own. But I have no evidence or argument to support that.

My comments about team ownership in other sports are here.

Free-agent horses: a better hobby than an investment

A few months ago, I wrote that professional sports teams return very little profit compared to other investments. My argument was that owning a team is the way for rich people to gain fame and have fun playing fantasy sports with real money.

Here's an argument from William Baldwin of Forbes that says horse racing is the same thing – a supposed business that's really just a hobby. Baldwin calculates that, across all racehorse owners, the cost of upkeep is $2 billion, but there's less than $1 billion in purses to go around. Conclusion: owners know that they stand to lose half their investment, but continue anyway because they're not in it just for the money.

Baldwin's article is actually an editor's note commenting on another article that appeared in the same issue. That story, by Dan Seligman, talks about a horse auction where animals go for millions of dollars, a lot like promising free-agents. Seligman is one of my favorite journalists (although I haven't seen much of his work lately). He's not afraid of numbers, and he understands what they mean and what they don’t mean; I don't recall a statistical argument of his that I thought was unsound.

In this article, he does a bit of original sabermetrics, finding a correlation of 0.4 between horse "tryout camp" results and eventual sale price. I trust his findings a lot more than if he had gone out and quoted some supposed expert somewhere.

Additionally, the article suggests that free agent horses are wildly overpaid. Of 22 horses that sold for over $1 million, only one earned back his million in purses. A lot of their income comes from stud fees -- old blue-chip horses siring young speculative horses.

If Forbes is right about the horse business, you should expect to find it all privately owned (like baseball teams and Picassos). It would be difficult to sell shares in a a business where you lose more than 50% of your capital every year.

Why do NHL teams make so little money?

Last week, Forbes magazine released its annual report on NHL team finances.

In 2004-05, the Toronto Maple Leafs had the highest operating income -- $41.5 million US -- while the New Jersey Devils were the biggest money losers, at negative $6.7 million. These are all Forbes estimates; I believe that the teams don't release their financials publicly. (And for those scoring at home, earnings figures are EBITDA.)

Also interesting are Forbes estimates of what each team is worth. The Leafs again top the list with an enterprise value of $332 million, and the Washington Capitals are at the bottom, at $127 million. The median is $153 million. The Buffalo Sabres were the biggest gainer over the last two years, going from $104 million to $149 million. Forbes attributes the increase to Thomas Golisano, the Sabres' new owner, who cut front-office jobs, reduced ticket prices, and improved his team by telling the coaches to make the players practice shooting more. (Seriously, that's what the article says.)

What strikes me about the numbers is the crappy rate of return the owners are getting on their investment. The average team is worth $180 million, but earned only $4.2 million. That's an "enterprise multiple" of about 43. That's huge. By comparison, Home Depot trades at about 7, IBM is at 9, McDonald's is at 10, and Coca-Cola is at 14.

Put another way, the owner who invested $180 million and made $4.2 million earned a return of only 2.3%. He could have earned 4%, risk-free, by selling the team and putting the $180 million into government bonds. Or, roughly speaking, he could have bought $180 million worth of IBM stock, and earned 11% instead of 2.3%.

According to standard economic theory, a return of only 2.3% can't persist in the long term, at least if owners are rational. So what's going on? One possibility is that last year's NHL income could have been abnormally low – the league was having a bad year, and owners (and potential buyers of their teams) expect higher earnings in the years ahead. That doesn't sound plausible to me, especially because last year's earnings already include the effects of the salary cap. Also, to pull even with other investments, team earnings would have to at least triple. I don't see that happening, but, then again, I don’t know all that much about the business of sports, and I might be misunderstanding all these numbers.

Another possibility is that Forbes has overestimated team values. But their numbers seem to be close to what teams have sold for recently. For instance, Eugene Melnyk bought the Ottawa Senators in 2003 for $127.5 million Canadian, and Forbes says the team is now worth $159 million US. The Devils were sold for $175 million in 2000, and now Forbes has them at $148 million. (However, Forbes' values include debt, while the sale prices quoted in the press may not.) My feeling is that the numbers are correct – after all Forbes knows accounting, and I don’t.

But I think sports franchises are always going to earn less money than other businesses. Why? Because the people who buy sports teams aren't doing it just for investment purposes; they're doing it for ego and status and fun. A hockey team isn't something you buy and forget about, like a share of General Motors stock. It's partly a consumer good, like an antique car or a Honus Wagner hockey card. A large part of its value is the benefits other than cash earnings.

If you were a billionaire, how would you spend your vast wealth? The truth is, you couldn't. Even if you invested everything in government bonds at 4%, you'd earn forty million dollars a year. That's $109,000 a day, every day, even before touching the principal. If you absolutely had to get rid of that much money, you'd have to spend it on exotic stuff, like trips into space, or Van Goghs, or huge diamonds.

Or a sports team.

Suppose you sold some of your investments to buy the Ottawa Senators at the Forbes price of $159 million. You'd be giving up about $10-$15 million in earnings from your investments. The Senators would earn you only about $4 million. So the cost of owning the team for a season is about $8 million.

The Senators are actually owned by a man named Eugene Melnyk. Eight million dollars is about one-half of one percent of his net worth. For that, what does Melnyk get? A lot. He gets fame – everyone in Ottawa knows him now. He gets his name in the papers, and his face on TV. He gets respect and admiration. He gets the best seat in the house for games. He gets to run a hockey team, or at least select the people who will. He gets to decide how much to spend on players, and maybe even input on who to sigh for how much. Basically, he gets to own a fantasy league team, except that it's no fantasy.

All that is a huge bargain at $8 million a year. Think about it. If you had so much money that $8 million was a drop in the bucket, wouldn't you want to own a sports franchise? I sure would. As soon as I make my first couple of billion, I'm making an offer for my beloved Toronto Maple Leafs, opportunity cost be damned.

If this theory is true – if sports teams weren't just profit-making institutions, but also consumer goods for people who are extraordinarily rich – what should we expect to see?

1. Teams would be owned by individuals, rather than corporations, because corporations don't have egos and care only about the bottom line.

2. Where rule number 1 doesn't hold, and teams *are* owned by corporations, it would be those where a single individual or family owns most of the voting shares, and where an individual from that family is the face of ownership.

3. Where rule number 2 doesn't hold, and teams *are* owned by widely-held corporations, it will be mostly teams that are profitable, and earn a reasonable return on the market value of the franchise.

4. Sports will have a larger proportion of egoist owners than other corporate fields. Owners will have a larger presence in the community than owners of other businesses. Absentee or reclusive owners will be rare.

5. Different owners will have different priorities. Some owners will concentrate more on making money and less on winning, while others will concentrate more on winning, even taking substantial financial hits to do so.

6. Losses will be widespread and returns on investment will be low. Some owners will make decisions that do not appear to make sense financially, in pursuit of something other than just profits.

7. Because the supply of billionaires increases faster than the supply of sports teams, demand will rapidly bid up the market value of a franchise, even past the point of profitability.

And all these things are roughly true, I think.

So, does this mean that sports teams are a bad investment? Not necessarily. It does mean that teams, as a whole, will never show a profit as good as other investments with equal market value. But it is quite possible that demand for teams is increasing so fast that there's a lot of money to be made buying a team, holding it for a few years, and flipping it to the next bored billionaire. It's kind of like buying the Mona Lisa for a billion dollars. You won't earn much charging admission to see it, but that's OK, because, unlike IBM, its value isn't based on its income stream. Eventually, as society gets richer and richer but Mona Lisas stay rare, the price gets bid up until someone will pay more than you will.

I don't think that sports teams will never earn a full economic profit. They are mostly expensive toys.

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UPDATE: Tango coined the phrase "Picasso Effect" to describe this phenomenon. Subsequent posts on this topic can be found by searching for "picasso".