Arnold Kling  

Contemporary Tulip Bulbs

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The Wall Street Journal reports,


Profitable sports franchises may be priced at 20 times annual cash flow, at least double the valuation of a mundane company with similar prospects. Weaker teams can sustain operating losses of $10 million a year or more, before taking into account debt service and noncash charges such as depreciation and amortization.

In my intro econ class, I use a hypothetical sports franchise as an example of an asset where the interest cost exceeds the income, with capital appreciation making up the difference. Suppose that the franchise costs $100 million, net earnings are $5 million, and the interest rate is 6 percent, so that the imputed interest cost is $6 million. The operating loss would be $1 million a year. However, as long as franchise prices are going up at, say, 2 percent per year, it's still a profitable investment.

Why do sports franchise values keep going up? For the same reason that tulip bulb prices rose during Dutch tulip mania. Back then, the price of a rare tulip bulb depended on the price that the next rich person was willing to pay for it. And for a while the number of rich people interested in tulip bulbs was increasing.

I think that the U.S. has an increasing number of rich people interested in owning sports franchises. So, for a while at least, franchise prices can continue to increase.

Incidentally, I think that newspapers are going to be similar. They will be owned by wealthy individuals, and they will be profitable investments as long as there is another wealthy individual willing to own a newspaper franchise.


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COMMENTS (13 to date)
eric writes:

I think there's a rule here, that whenever the investment is not based on cash flow, even projected cash flow, but rather, increases in collateral or asset value, you are in a bubble. That was the essence of "Ponzi Finance" of Hyman Minsky (see his Stabilizing an Unstable Economy).

That was the essence of the subprime housing logic, why one would lend to someone who could not afford the loan--there are no losses because the collateral goes up 8% a year even in recessions! There was 'equity based' lending in the late 1990s, and HLTs (Highly Levered Transactions) in the late 1980s.

Its really obvious once you think about it. If you truly think cash flows alone cannont justify an investment, at what point will potential buyers come around to your view?

Bob writes:

Eric,

I largely agree with your sentiment, but your definition seems to unavoidably include gold, art, etc.. You can argue that these are not "investments" but not, I think, that they are perpetually in a "bubble."

8 writes:

I think most owners value their team the same way car enthusiasts value their classic car.

Part of the value is wrapped in the social value too. Unless baseball becomes unpopular, being the owner of a baseball team has large non-monetary benefits.

Ross Williams writes:

Arnold, the Tulipmania idea doesn't actually seem to follow much of a bigger fool effect and seems to have been triggered by real supply shocks, as well as changes in contract structure. See the Public Choice (2006) 130 article by Earl A. Thompson "The tulipmania: Fact or artifact?"

Dan Weber writes:

The supply of sports teams is also highly constrained. You could probably handwrite all the sports teams on one piece of paper, and hardly ever have to edit it.

How is the market for WNBA teams? Or arena football? Whatever happened to the XFL?

ds writes:

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Phil writes:

In support of this theory: in the NHL, the average team made (operating income) about 2.3% of market value. But the teams owned by institutions or corporations made 12.5% (Leafs), 5.8% (Rangers), 0.3% (Flyers), and 7.6% (Canadiens) -- overall, substantially above average.

Corporations don't get the social benefits of being a bigshot owner, so they insist on an actual return on their investment.

Phil writes:

In the circle of sports stats guys I've discussed this with, we call sports teams "Picassos" rather than "tulip bulbs." The tulip bulb analogy implies that rich owners' main motivation is profit. I think it makes more sense that, while profit is certainly nice, it's ego and pride of ownership that are the prime motivators.

bp writes:

Why do we believe these numbers? There are many reasons (revenue sharing, fan appearances, government welfare) for sports franchises to understate their profitability. Its also a complex business with many revenue streams (parking, concessions, merchandising) to account for. For example the owner contracts out to a company, that he also owns, to control parking and crowd control. He pays too much, so the sports franchise looks less profitable, but since he owns the other company it makes no difference to him. Maybe its harder to play these types of games with a corporate owner, and thats why they appear more profitable.

151 writes:

The magic of sports franchises is the steadily growing rights fees they generate from existing and new forms of media (radio, network tv, cable, internet). Historically this growth has outstripped inflation or even GDP.

Since the return on an investment is the cash flow you generate plus the rate of growth of that cash flow, it's not hard to see how you can get a good return from this type of investment.

I believe Warren Buffett once commented that buying an NFL franchise would have been the best investment you could have made if you went back in time a few decades, for this reason. If you look at the numbers, this sounds about right.

Certainly valuations for sports franchises get out of hand from time to time, but it doesn't sound like this is generally the case right now.

Barkley Rosser writes:

Obviously these bad numbers are one of the reasons why these owners are constantly running to city governments to obtain all kinds of subsidies. That such subsidies are losing propositions for the cities involved (although maybe not for the mayors and city council members getting into those skybox seats) has been well and widely documented. Among the scams pulled is the milabeling in the various "studies" as "multiplier effects" what are almost always merely substitution effects, e.g. all those food and drink sales are not net gains to the city economy but taking away from other existing establishments.

Regarding bubbles in general, there is usually the problem of the "misspecified fundamental," although I probably should not get so technical here on a blog. So, one never knows that a given price does not reflect a rational expectation of some as yet unobserved future stream of increases in net earnings. Even after the fact, if the "bubble" collapses with no such stream forthcoming, one can still say that this was just a "bad tail" outcome out of a rationally expected, but empirically unobservable, distribution. Such could be said of the Great Depression and the behavior of the stock market before it.

BTW, there are some exceptions to this problem, notably closed-end funds, where the there is a clear net asset value, which often deviates from the fund's market value. Of course, there may be some explanations for such deviations, especially for discounts, due to taxes or liquidity issues. However, if one sees a large premium appearing, which then suddenly disappears, one can be about as certain as one can be that one actually did observe an honest-to-gosh speculative bubble. So, Barsky and DeLong have argued that while nobody can prove that the 1929 US stock market exhibited a speculative bubble, we can be pretty certain that closed-end funds containing such stocks did as they ran up to over 100% premia during 1929, which largely turned into discounts after the late-in-the year crash of both their markets along with the market for the stocks that went into their funds.

Ajay writes:

Sorry to say, Arnold, but I think you're dead wrong in your analysis. The big problem is that you're merely extrapolating current trends rather than analyzing underlying technological changes for how they might disrupt the status quo (over-simplified extrapolation is the same flawed logic that led to the dot.com bubble, btw). For sports franchises, I commented on a previous article of yours that this is a bubble, caused by monopoly distribution networks, that is soon to burst. Just as cable TV led to the rise of new sports like skateboarding or the X-games, the low cost of internet video will lead to an explosion of sports league possibilities. One possible example might be a 6'6" and under basketball league; I know I'd rather watch something like this than the NBA and I'm a big NBA fan. I can envision the invention and proliferation of entirely new sports once distribution through internet video is cheap and easy, which it's almost at. As for newspapers, you're not even extrapolating but wildly guessing, as most newspapers are currently owned by or operated as public corporations. The newspaper business is about to be blown up and reconfigured to resemble the blogosphere. You can already see the future in blog news networks like Gawker Media or GigaOmniMedia that are funded by online advertising. Once a micropayment system is widely deployed on the internet, you will see news reporting done by small, widely decentralized teams of reporters and editors. The reasons newspapers have been more centralized so far are the costs of printing (printing presses), distributing (delivery vans and drivers), and searching (branding/categorization, you look for local news in the local paper and world economic news in The Economist) that are associated with physical products and that benefit from economies of scale. With the invention and wide deployment of computers and the internet, printing and distribution costs have been cut to negligible amounts. All that's left is to make payment easy with micropayments and to further develop content search like Digg or Google News so that it's easy to find the best content for you.

I'd also like to address Barkley's point about how bubbles can reflect rational notions of future earnings. Many smart people during the bubble expected that one of the many competing micropayment systems of the time would succeed and moved forward with their plans under the assumption that monetization would not be an issue as a result. Obviously, no micropayment system took off and they ended up being temporarily wrong about this. Another assumption of the time, one that was incredibly stupid, was that early entry into various online markets would protect them from future competition, what was called "first mover advantage", and that was how they justified the insane valuations of the time. Of course, this was a stupid argument to begin with so any companies that were pumped up as a result deserved to deflate. I would attribute the dot.com bubble to these two arguments, one justified and the other patently stupid, and agree with Barkley that it can be difficult to say whether one is in a bubble or not.

Sorge L. Diaz writes:

Those are two excellent examples.

Some very wealthy people are attracted to sports franchises because of their glamor and entertainment--they are a great toy for them. Other subset of wealthy people are interested in newspapers because of the influence that comes with owning them. In each case, the value of the franchise or newspaper is not restricted to its cash value. In one case, they provide entertainment and social prestige, in the other, they provide political power. Both sports franchises and newspapers are not merely investments, but goods that are consumed.

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