Use of Price to Revenue Ratio in Valuing Sports Franchises
The valuation of a sports franchise is a very difficult task. This is because a lot of the rules that are applicable while valuing other businesses are not relevant when it comes to valuing sports franchises. One such example is the widespread usage of the price-to-revenue ratio in deriving the valuation of a franchise.
In other businesses, the value of a business is generally expressed in the form of price to earning ratio. However, this is not the case when it comes to sports franchises. Here, the valuation is expressed in terms of a price-to-revenue ratio. Over the years, the price-to-revenue ratio has become a very important number in this industry.
In this article, we will have a look at some of the reasons that make the price-to-revenue ratio one of the most important factors while valuing a sports franchise.
- Sportsman Effect: In most businesses around the world, the current earnings can be seen as an indicator of future earnings. This is the reason that the price-to-earnings ratio is considered to be an important factor during valuation. However, this is not the case in the sports industry.
As far as the sports industry is concerned, the current earnings of a sports franchise could be less because a large portion of the funds may be spent on recruiting and training the best talent. These efforts are likely to produce more wins in the forthcoming years and once the percentage of wins starts increasing for the team, there is a sudden increase in the earnings, and also capital appreciation takes place. This is commonly known as the sportsman owner effect. This is one of the main reasons why earnings are not considered to be very important in the valuation of sports franchises.
- Statistical Correlation: Analysts from the industry have collected data related to the valuation of sports franchises and have checked the correlation of the valuation number with different numbers on the income statement. The results of their study confirm the fact that revenue is more important than earnings when it comes to the valuation of sports franchises.
For example, the statistical correlation of the revenue of the sporting franchise with its valuation is very high at 0.69. On the other hand, the statistical correlation of the earnings of the franchise with its valuation is very low at 0.14 which is as good as 0.
- Volatility: Another problem with using earnings in order to value a sporting franchise is the fact that the earnings of sporting franchises tend to be quite volatile. The revenues of sporting franchises on the other hand have been known to be relatively stable markers of valuation.
It is important to understand that the sports industry is cyclical in nature. This means that the earnings can fluctuate wildly from year to year based on certain factors. In such cases, price to revenue ratio is a more important barometer for the valuation of the firm.
Hence, historically teams have been valued based on their revenue. As a result, a convention has been created over the years wherein the revenue is considered to be the starting point for valuation.
- Negative Earnings: We have already discussed the fact that many times sporting franchises are trophy purchases for their owners. This means that they do not necessarily derive their value from their cash flow or their earnings.
Many times, owners just consider the monetary value of the publicity generated by the firm and continue to run the franchise even if it is running in losses. Now, it needs to be understood that the earnings of any firm must be positive for a positive price-to-earnings ratio to work and provide a valuation.
As per this formula, the valuation of franchises with a negative income or a negative cash flow should be zero. However, this is not the case. These firms also have a positive valuation. Since negative cash flows or income is not very unusual in the sporting business, the use of revenue to price ratio is considered to be unsuitable.
- Easier to Obtain Data: The price-to-revenue ratio is widely used in the sporting industry since it is easier for investors to derive information about the top line of a company as compared to deriving information about its profits. This is because top-line information can be easily guessed using publicly available information. However, the expenses being made by a franchise can be difficult to predict.
Hence, in many cases, prospective investors do not know the earnings figure at all. Hence, they are not in a position to use the price-to-earnings ratio. In such cases, they are better off using the price-to-revenue ratio instead since it’s a close proxy and the information is available with much less effort.
- Adjustment Factor: It is important to note that the price-to-revenue ratio does not provide the final valuation. Instead, it provides a ballpark figure which can be used as a starting point for more detailed calculations.
The particular pros and cons of the sporting franchise in question need to be evaluated separately and an adjustment factor must be used so that these peculiar characteristics of the business are reflected in the valuation.
Hence, the price-to-revenue ratio is an important number that is used to predictably and accurately derive the valuation of a sporting franchise.
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