Valuation of Sports Franchise: Replacement Cost Approach

In the previous few articles, we have already come across the income-based approaches that are used in order to value a sports franchise. We have also had a closer look at some of the shortcomings of the income-based approach.

We are also aware that the income-based approach is not the only possible way to value a sporting franchise. There are other methods that can be used to value sporting franchises as well.

The replacement cost approach is another method that is used to value sporting franchises across the world. In this article, we will have a closer look at what the replacement cost method is as well as how it can be used to arrive at a valuation for sporting franchises.

What is the Replacement Cost Approach?

The basic concept of the replacement cost approach is built on the economic principle of utility. The central idea is that a buyer will not be willing to pay any more for an asset i.e. a sporting franchise, than it would cost to rebuild the same. Notice that the focus is being changed from income to costs here.

The amount of cash flow that the sporting franchise may or may not be able to generate becomes irrelevant under this approach. Instead, the focus is shifted toward the costs that will be required to create the same asset.

It is important to note that the replacement cost approach is supposed to specify the replacement cost of an asset in current dollar terms i.e. after taking changes in the value of the asset into account. This means that the inflation costs as well as the depreciation costs must be taken into account.

Types of Replacement Costs

When it comes to replacement costs, there are two types of costs that are commonly discussed. These terms are replacement cost and reproduction cost. There is a very minor difference between the two. However, the valuation numbers can be quite different if different approaches are used.

Replacement cost is the cost of creating an asset that provides a similar value to the original asset in consideration. This means that the replacement cost of an Indian Premier League team such as Chennai Super Kings will be the cost required to recreate a team that provides a similar economic utility.

It needs to be understood that the word “similar” is being used and not the word “same”. Hence, replacement cost theory would assume the cost of obtaining a grade-A player like MS Dhoni for the team. The player needs to have a similar popularity such as MS Dhoni. However, the player does not need to be exactly the same. Hence, as per replacement cost theory, the prices are comparatively lower since there is no inelastic demand. The people trying to replace the original team can look at other similar options.

This is not the case with the reproduction cost approach. The reproduction approach assumes that the exact same team would have to be replicated with the exact same assets and liabilities that are in place as of now. This means that the cost to replicate such a team would be the sum of costs required to replicate the player contracts, the stadium leases, etc. If even one player’s contract is changed, then the related cost cannot be considered to be a reproduction cost.

The original asset and the hypothetical new asset being produced have to be exactly identical in order for the comparison to be valid. Needless to say, this exercise is purely theoretical and may almost be impossible to replicate.

Also, the prices derived using this valuation method are relatively higher as compared to the replacement method. However, the replacement cost approach is considered to be the more pragmatic approach and is hence used by a larger number of people.

Understanding Cost Vs Value

It needs to be understood that the replacement cost of an asset is not the same thing as its value. This is because the tangible as well as the intangible assets are regularly used. Hence, their useful life decreases because of obsolescence and depreciation.

For example, a large part of the valuation of the Chennai Super Kings cricket franchise is derived from the brand value of MS Dhoni as an individual player. However, while valuing the company, it needs to be taken into account that MS Dhoni’s contract can end soon and that he is moving closer to his retirement. Hence, adjustments need to be made to the replacement costs in order to reflect the true value of the asset i.e. the sporting franchise in consideration.

Therefore, the replacement cost is not the final value of the sporting franchise. Instead, it needs to be taken as a starting point in the valuation process. Various adjustments need to be made in order to take into account the present conditions of the franchise and derive the final value.

The bottom line is that replacement cost is a viable method that is used by certain investors across the world to derive the valuation of sporting franchises.