In the previous article, we have already seen how the valuation of a sporting franchise can be found using the income approach. This approach relies extensively on finding out the cash flow that is likely to accrue to the sporting franchise and then discounting it at a predetermined discount rate in order to find out the present value of the firm.

Now, people who are familiar with the discounted cash flow process must also be aware of the fact that the present value of any firm is highly sensitive to its discount rate. This means that minor changes in the discount rate end up producing significant changes in the present value of the firm.

It is for this reason that selecting the appropriate discount rate is very important from the point of view of the discount rate calculation.

It is also a known fact that approximating the correct discount rate is a subjective and difficult process in general. This difficulty gets compounded when the discount rate is being derived in order to value a sports franchise.

In this article, we will have a closer look at how the discount rate is derived.

Weighted Average Cost of Capital (WACC)

There are many methods that are used to derive the weighted average cost of capital for any business. The most common method used is the weighted average cost of capital method.

This method assumes that the business is funded by debt and equity in a given proportion and hence the same proportion must be used as weights along with the respective cost of capital. This means that a weighted average cost of capital must be derived by multiplying the cost of debt with the proportion of debt in the overall funding of the firm and the same should also be done for equity. The blended rate derived after performing this calculation is called the weighted average cost of capital.

Now, it needs to be understood that deriving the cost of debt is easy since it is an actual payment that is made by the firm to other entities. However, this cannot be said about deriving the cost of equity.

The cost of equity is not really a payment that is actually made in cash. Hence, the cost of equity is a notional figure which needs to be derived. Across all industries, this is generally done by using the capital asset pricing model.

Cost of Equity as Per Capital Asset Pricing Model

The cost of equity as per the capital asset pricing model is as follows:

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

1. Risk-Free Rate: The risk-free rate is the rate at which investors are willing to invest their money in case there is no risk.

   The only scenario which can be technically considered risk-free is when the money is lent out to the government. This is because the government has the power to print additional money if required. Hence, the prevailing yield for government securities can be easily derived and used in the formula.

2. Beta: Beta refers to the riskiness of the particular firm or industry with respect to the overall market. For instance, the riskiness i.e. the volatility in the price of a particular stock can be compared with an index such as SP 500 in order to find the beta of that particular stock. Now when it comes to sports franchises, this creates a problem.

   The stock price movements of the sports franchise are not available generally because the stock is not listed on the exchange and hence there is no price data available to compare to an index. In such cases, it is common to use a comparable industry in order to estimate the beta.

   For example, data related to stocks from the entertainment industry can be used in order to estimate the beta applicable to sports franchises. However, it must be understood that this component is estimated and not mathematically derived from the equation.

3. Equity Risk Premium: Equity risk premium is the additional compensation that shareholders demand in order to stay invested in equity. This equity risk premium can be derived by subtracting the risk-free rate from the return of the overall index. Now, both these numbers are easily available in the public domain and hence can be easily derived.

4. Excess Small Company Risk Premium: We can see from the above formula that there is no component called small company risk premium mentioned. However, it is widely known and understood that the cost of equity calculated by using the capital asset pricing model is for larger companies.

   Now, sports franchises are generally much smaller in terms of revenue and other financial parameters. Hence, investing in sports franchises is often considered to be akin to investing in smaller companies. Hence, it is common for some investors to add a small company risk premium to the figure derived by using the capital asset pricing model.

Hence, the fact of the matter is that estimating the discount rate for calculating the present value of sports franchises can be a very difficult task. This is because of a wide variety of reasons. Some of the reasons have been discussed in this article whereas some others will be discussed in the forthcoming articles.