Issues in Determining Discount Rate for Valuation of Sports Franchises
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:
- Lack of Comparable Companies: First and foremost, it is important to realize that the discount rate can be accurately calculated for an organization for which daily pricing details are available.
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.
- Use of Single Discount Rate: As mentioned above, there are very few comparable companies listed on stock exchanges for which price data is easily available. Generally, there are one or two such companies in a country. As a result, all the sports franchises in the country are forced to consider these companies as proxies.
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.
- Negative Cash Flows: The purpose of a discount rate is to discount the positive cash flows that will accrue to the sporting franchise at a later date in order to derive its present value. However, when it comes to sporting franchises, this may not always be the case.
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.
- Does Not Take Forex Risks into Account: It is important to note that it is possible for sporting franchises to have business interests in different parts of the world. For instance, there could be ticket sales revenue and merchandise sales revenue which could accrue to the franchise in a different currency.
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.
- Does Not Take Liquidity Issues into Account: The capital asset pricing model takes into account securities for which daily pricing is available in the market. Now, when prices change every day, the investors have an option to buy or sell more shares. Hence, there is a self-corrective mechanism which is in place as a result of this increased liquidity. This is completely different from shares of sporting franchises.
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.
- Does Not Take Control into Account: Last but not least, it is important to note that when an investor gains a controlling stake in any entity, they have a higher chance of influencing the decision-making process. As a result, the risk gets reduced to a large extent. This reduced risk should be reflected in the discount rate as well.
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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