THE ROI OF ESCALATING PLAYER SALARIES IN MAJOR LEAGUE BASEBALL: THE IMPACT OF PAYROLL ON FRANCHISE VALUATION by John A. Eastman Submitted in partial fulfillment of the requirements for Departmental Honors in the Department of Finance Texas Christian University Fort Worth, Texas May 5, 2014 ii THE ROI OF ESCALATING PLAYER SALARIES IN MAJOR LEAGUE BASEBALL: THE IMPACT OF PAYROLL ON FRANCHISE VALUATION Project Approved: Supervising Professor: Vassil Mihov, Ph.D. Department of Finance George Low, Ph.D. Department of Marketing Peter Locke, Ph.D. Department of Finance iii ABSTRACT This study focused on the impact of payroll investment on the intrinsic value of Major League Baseball franchises. Specifically, I examined how club owners allocate capital to their most crucial and fundamental investment – players – and how payroll impacts teams’ financial and on-field performance. I addressed this question empirically first by examining the financial trends of the MLB as a whole and the thirty organizations within. Given these observations, I created a simple five-variable model of team revenue. Because outstanding research has indicated that revenue should be the basis for valuation of professional sports teams, this model was meant to reflect the strength of payroll as a predictor of franchise value relative to other key variables, particularly market size, winning percentage, club tradition, and home attendance. The results of my analysis supported my hypothesis that payroll would be a strong and statistically significant predictor of revenue and, therefore, value, so long as franchises are to be valued based on their revenues. Implications for owners, researchers who have studied the business of baseball, and fans of the sport in general are discussed. iv TABLE OF CONTENTS INTRODUCTION .............................................................................................................. 1 LITERATURE REVIEW ................................................................................................... 4 Baseball as a Business ............................................................................................ 4 The Labor Market in Major League Baseball ............................................. 4 The Impact of Payroll ................................................................................. 8 Balancing the Score Line with the Bottom Line: A Dilemma for Owners ............. 9 Competitive Balance in Major League Baseball .................................................. 11 The Importance of Market Size ................................................................ 11 Promoting Competitive Balance ............................................................... 12 How to Value Professional Sports Franchises ...................................................... 17 METHODS & RESULTS ................................................................................................. 20 Financial Data ....................................................................................................... 23 Other Data ............................................................................................................. 25 Observations ......................................................................................................... 26 The Average MLB Franchise.................................................................... 26 “Have”....................................................................................................... 27 “Have-Not” ............................................................................................... 29 Model .................................................................................................................... 32 Results ................................................................................................................... 35 DISCUSSION ................................................................................................................... 38 IMPLICATIONS .............................................................................................................. 43 CONCLUSION ................................................................................................................. 47 v APPENDIX A: MLB LUXURY TAX DATA ................................................................. 51 APPENDIX B: MLB REVENUE BREAKDOWN, 2013................................................ 52 APPENDIX C: PAYROLL AS A PERCENT OF REVENUE ........................................ 53 REFERENCES ................................................................................................................. 54 1 INTRODUCTION The game of baseball in the United States is highly popular in terms of both consumer interest and professional research. In Ken Burns’ 1994 documentary series, Baseball, the narrator describes the sport as “an American odyssey that links sons and daughters to fathers and grandfathers.” Behind this timeless game, though, lies a complex and powerful commercial enterprise. Perhaps the best example of the scope of baseball’s economic prowess is the 2011 sale of the then-struggling Los Angeles Dodgers – a deal reportedly worth $2.15 billion, more than twice that of any franchise sale preceding it (Dixon, 2013). The Dodgers have since gone on a spending spree, acquiring high-ticket players such as Adrian Gonzalez and Zack Greinke, and in the process the franchise has more than doubled its payroll distributions, from $95 million in 2012 to a projected $235 million heading into the 2014 season (Blum, 2014). Baseball remains, of course, a beautiful game and one of the great cultural creations in United States history, but, as Burns’ documentary went on to describe, baseball also “reflects a host of age-old American tensions: between workers and owners, scandal and reform, the individual and the collective.” Given the absence of a salary cap and the availability of more than a century of documented player statistics, which allow for precise analysis of the revenue-generating ability of any given player, Major League Baseball provides the opportunity for revelatory analysis of its labor market and the compensation trends therein. Consequently, literature on professional baseball is extensive. Existing literature frequently explores baseball as a business, seeking to understand the drivers of the league’s revenues and profitability. Due to the publicity of 2 escalating player salaries, many professionals have researched how to assess the monetary value of players to their respective franchises to determine the fairness of their compensation. Competitive balance in baseball has also been the subject of extensive research, primarily because the MLB is noticeably less “competitive” than other professional sports leagues due to the great disparity between the financial clout and on- field success of different clubs. Analysts and fans want to understand why success in the league is concentrated among relatively few teams, why revenue-generating ability and profitability vary so greatly, and why some teams invest substantially more in obtaining and retaining high-quality players than others. Each year, Forbes publishes a widely referenced article that provides financial data for each of the MLB teams as well as an estimate of each franchise’s value based on a multiple of that club’s revenue. Other research exists that examines the valuation of professional sports franchises, but relative to the extensive body of literature on baseball, research on this topic is limited. What existing literature and valuation models do not explicitly address is the relationship between team payrolls and franchise value, specifically, the extent to which payroll affects the value of an organization. The purpose of my research is to delve more deeply into this concept. In this paper, I review the relationship between the increasing salaries of professional baseball players and the effect that they have, or should have, on the value of their respective franchises. I explore whether these increasing salaries drive franchise success (and, therefore, value), or whether value created from another source simply allows these franchises to pay athletes more. I intend to use my conclusions to make a more general connection between professional baseball compensation and the impact of 3 corporate salaries on firm value. Further, I hope that my conclusions will be able to shed some light on the effectiveness of outstanding valuation models in capturing the impact that player salaries have on franchise value. Existing theory displays a noticeable departure from traditional valuation methodology, so I will address this departure and the reasons why it may or may not be the most accurate approach to franchise valuation. This study should be of particular interest to those who have researched or are intrigued by the business of baseball, those concerned with the trend of sharply escalating salaries among major league players, owners and managers whose on-field and economic success depends heavily on their investment in players, and baseball fans in general. These questions are primarily addressed empirically from a couple of different angles using data from 2006 to 2013. First, I examine the financial foundation of the MLB and its franchises to formalize a better understanding of the drivers of value in professional baseball organizations. I also provide analysis of individual teams that I believe present informative examples of performance trends, both