Replacement Cost Approach Advantages and Disadvantages

In the previous article, we have already witnessed what replacement cost theory is and how it can be used to value sporting franchises. We now know the theoretical aspects of this type of valuation.

We also know that the replacement cost approach is not used very widely when it comes to the valuation of sports franchises. This is because there are more downsides to using this approach than there are upsides.

In this article, we will have a closer look at both the downsides as well as the upsides of using replacement costs in order to value sporting franchises. The main points have been mentioned below:

Benefits of Replacement Cost Approach

The main benefits of using the replacement cost approach in order to calculate the valuation of any sports franchise are as follows:

1. Valuation of Intangible Assets: The main benefit of replacement cost theory is that it takes both tangible and intangible assets into account while calculating the valuation of a sporting franchise. This is not the case when income-based valuation is used. Also, when it comes to the valuation of intangible assets, the brand value and the value of player contracts are also taken into account.

   Estimates are made to understand how much money would be required to build a similar brand name at current prices. Hence, all assets including intangible ones are fairly valued without any consideration to cash flows which they may or may not provide.

2. Takes Inflation and Market Condition into Account: Another important benefit of using the replacement cost approach is that the replacement cost is calculated in today’s dollar terms. This means that the method has been created to implicitly take into account the inflation costs as well as the market conditions. This is because if the market for football has started growing at a rapid pace in recent times, then automatically the valuation calculated using the replacement cost method will also be higher.

Disadvantages of the Replacement Cost Approach

There are more disadvantages of using the replacement cost approach vis-a-vis the advantages. Some of the main pain points have been mentioned below:

1. Difficult to Replicate: The main assumption behind the use of the replacement cost model is that a certain amount of money can be spent today to create a similar brand image as compared to another club. However, this assumption is not completely correct.

   It needs to be understood that building a sporting franchise that has a loyal fan following and a brand name cannot easily be done in a very short span of time.

   Brand names related to sporting franchises are built over many years as a result of the performance of the firm. This cannot be built instantly even if a lot of money is spent. Hence, it can be said that the basic premise of the valuation method is flawed.

2. Entry Barriers: The replacement cost method assumes that the same sporting franchise can be created if a certain amount of money is spent. However, this is not the case. There are entry barriers that have been created in most leagues by the management of that league.

   Hence, only a certain number of franchises are permitted to operate. Therefore, supply is generally controlled and if a new buyer wants to own a team, they need to buy one since there is no option of creating a new team.

   The replacement cost theory might be effective in other industries where entry barriers are not present. However, it cannot be used to value a sporting franchise since its supply is controlled.

3. Overvaluation: An empirical analysis of the replacement cost method tells us that this method is generally used to justify the sky-high valuations of certain asset classes.

   There are many experts who believe that the replacement cost method is not genuinely applicable when it comes to the valuation of sports franchises. It is being used to provide an academic cover to reverse engineer and make sense of the sky-high valuations that are provided to sporting franchises.

4. Lack of Information: It also needs to be taken into account that the type of information which is required to do valuation using the replacement cost method is not easily available.

   For example, it may not be possible to build the same assets since the same material is no longer used or the government no longer provides permits to build some assets. Similarly, information about brand equity and other intangible assets is not very easily available. As a result, it is not possible to come up with an accurate estimate.

5. Emphasis on Past: Last but not least, the replacement cost method is focused on the past. It pays attention to the types of assets that were created in the past as well as the cash flows that were generated in the past.

   It does not pay much attention to the future and the possibilities available there. Obviously, investors are more concerned with the future prospects and hence find this method to be unsuitable.

The fact of the matter is that the replacement cost method is not suitable for valuing sporting franchises. Since the supply is tightly controlled, it is not really possible to replicate the creation of a sporting franchise. However, it provides a good approximation of the overall value of the firm and can be used in conjunction with other methods even though it cannot be used directly.

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