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Profits and Franchise Value

Does this quote from Forbes make sense to you? Do you believe in the efficient market(s) hypothesis?

By Forbes calculations (see: "NFL Team Valuations"), the Patriots' enterprise value, now worth an estimated $861 million, grew 200% between 1998 and 2003--more than any team in the league. Yet the Pats lagged the league average in profitability (in the sense of earnings before interest, taxes, depreciation and amortization, all divided by enterprise value [emphasis added]) in both years it won the Super Bowl.

"Going sideways year to year is more than made up for in capital appreciation [of the franchise], presuming the owners have enough capital to pay their rent," says David Carter of The Sports Business Group, a marketing consultancy. "And most of those folks aren't pushing shopping carts."

Read the above quote carefully. A team wins the Super Bowl, its profits don't go up, but its franchise value triples? Typically in the Capital Asset Pricing Model (CAP-M), and using the concept of net present value, the franchise value should reflect expected future profits. Under this model, if profits (including media contracts, ancillary income, etc.) are expected to remain flat over time [move "sideways"], there is no reason to expect franchise values to increase, much less triple.

Now look at the portion of the quotation that I emphasized: "divided by enterprise value." What the financial data really show is that the rate of return on owners' equity did not change very much over time; that result is exactly what one would expect in an efficient capital market if nominal interest rates also did not change very much over that same time period. Profits went up and so did franchise values, commensurately.

The other interesting tidbit from this article is that the Patriots "lagged the league average" rate of return on net worth over this same period. This one puzzles me a bit. If the Patriots are not expected to continue winning so much in perpetuity, then markets should expect that their profits (adjusted for inflation) are temporarily high right now while they are winning and will fall in dollar terms in the future. This expectation should lead to a lower net present value and hence a lower franchise value. If anything, when profits are transitorily high, the rate of return on franchise value should be higher than average.

Does this mean the Patriots are under-valued? Or does it simply reflect the wide margin for error in public estimates of profits and franchise values? My guess is that it is more likely the latter.