The Nordic Crisis of 1992
The Nordic crisis of 1992 refers to the series of bank runs and currency crisis that shook Finland, Sweden as well as Norway in the early 1990’s. This was the first major national banking crisis since the 1930’s (if wars are not taken into account). Thus, an important belief that the fractional reserve banking system […]
Home Country Bias
The activities of most investors have historically been limited to their home country. This is largely because earlier, there were rules which made the transfer of capital between countries an arduous process. Not only was the process complex, but it also took a lot of time and was riddled with transaction costs. This is the […]
Advantages of Using Cryptocurrency
The popularity of cryptocurrency has exploded over the past few years. Statistics clearly suggest that cryptocurrencies are one of the most widely traded financial assets today. This is obviously because of the fact that there are some advantages to using cryptocurrency. In this article, we will have a closer look at those advantages and try […]
Disadvantages of Using Cryptocurrencies
In the previous articles, we have read about the meteoric rise of cryptocurrencies. We know that investments in these currencies have provided unprecedented returns. Many experts are attributing it to the number of advantages that cryptocurrencies have to offer. However, it needs to be understood that cryptocurrencies are still a nascent technology. Hence, there are […]
Investment Banking and Special Purpose Acquisition Companies (SPACs)
Special Purpose Acquisition Companies (SPAC) have become all the rage in the investment banking industry. They are not a new concept. They have been around for quite some time. However, they have become quite popular in the recent past. For instance, in the first half of 2020, $13.5 billion dollars were raised by Special Purpose […]
In the previous article, we have already understood the method used for deriving the discount rate which is used while deriving the valuation of sports franchises. The method was described in detail.
However, even though theoretically, there is a method available to derive the discount rate, there are several practical issues that make it difficult to derive such a rate.
It is these issues that make it difficult to value a sports franchise based on its cash flows.
Some of the main issues related to the derivation of discount rates while valuing sports franchises have been mentioned below:
Now, there are hardly two or three sports franchises around the world that are listed on the stock exchange. The vast majority of sports franchises across the world are privately held.
In fact, there are very few comparable companies that can be used to estimate this price data. This lack of data causes the analysts to use companies with very different risk profiles as proxies. The end result is that the cost of equity which is calculated does not accurately reflect the risk being undertaken by equity shareholders.
The end result is that almost the same discount rate is derived for all sporting franchises. This is certainly an anomaly since there are certain sports franchises that have a more established business and loyal fans as compared to other clubs that are not as popular.
For instance, it is possible for a sports franchise to have a negative cash flow for many years. Historically, there have been several sporting clubs that have accumulated losses and have had negative cash flows over the years. Later these clubs were sold at a premium price as well. Now, discount rates cannot mathematically work with negative cash flows. Hence, their applicability becomes limited when we consider scenarios wherein the cash flow is negative.
Now, wherever multiple currencies are involved, there is always a risk involved that the sporting franchise may face losses because of adverse movements in the values of such currencies.
In order for the valuation to be accurate, these risks should be reflected in the discount rate. However, forex risks are generally not considered while calculating the discount rate. Hence, as far as sporting franchises are concerned, these valuations cannot be considered to be accurate.
It needs to be understood that sporting franchises are not priced on an everyday basis. Hence, this lack of liquidity also means that there is no self-correcting mechanism in place that helps regulate the prices of such franchises. This increased illiquidity greatly increases the risks which accrue to the relevant shareholders. Hence, it is common for sporting franchise owners to add a liquidity premium to the cost of equity which they calculate after using the capital asset pricing model.
When it comes to sporting franchises, it is common for investors to buy majority and controlling stakes in the business. It is very uncommon for investors to buy a small share of such businesses. Hence, the usual discount rate calculated using the weighted average cost of capital does not take into account these risks.
The bottom line is that the weighted average cost of capital method is not suitable for the valuation of sports franchises for multiple reasons. There are several manual adjustments that should be made to the derived rate in order to make it relevant for the valuation of sporting franchises.
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