How Do You Sell a Basketball Team Owned by an Alleged Racist?
To answer this question we need to ask Bank of America (NYSE:BAC), who did a bang up job recently working on selling the Los Angeles Clippers to Microsoft's former CEO, Steve Ballmer, for $2 billion.
How did they come up with that valuation, and why does Mr. Ballmer want to pay that much?
Investment bankers can often produce a bit of financial voodoo, along with some modeling alchemy, to convince potential buyers that the business is worth more than the price he is willing to pay.
What BAC Bankers Are Paid To Do
It is important to remember that investment bankers are salespeople. They act as an agent for the seller to get the highest amount of money with the least amount of contingencies and act as part psychologist to both buyers and seller to "get the deal done".
The reason they live for the deal, is because that is where the money is. Investment bankers are paid based on the value a business or investment is sold at.
This deal-focused mentality appears to have played out financially well for the Sterlings and may (or may not) play out financially well for Mr. Ballmer.
The three most common ways to value a business are the following:
1. Cost Based Approach. This is based on the principle that a buyer would not be willing to pay more for an asset then it would cost to either replace of reproduce the asset, which produces the same cash flow. This approach is most often used when the business has significant tangible assets.
2. Market Approach. This is based on the principle that the value of an investment will be highly correlated with the value of other similar assets. An analyst can derive a baseline and then make adjustments based on determining factors that would increase or decrease the value of the investment.
3. Income Approach. This is based on the present value of future cash flows. An analyst can reverse engineer the financial drivers of the business that produces a model that approximate the expected cash flows the business would generate over the investment horizon.
Due to the large value placed on intangible assets in a sports franchise, the cost approach has not been a historically good indicator of value for a franchised sports team. Historically the market based and income approach valuation methods have been used to value sports franchise with greater weight placed on the market-based approach due to many franchises not producing an accounting profit.
The value of any business is the price at which the investment would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. This makes the market based approach the best indicator of value.
Unfortunately, the market based approach has the least amount of reliable data available and causes the greatest variability. A combination of the above approaches weighted based on a series of factors almost always produces a more accurate valuation.
BAC's Convenient Valuation Approach
BAC only used one valuation approach, the market approach.
They assumed a normalized revenue stream and then adjusted EBITDA, based on presumed additional cash flow from local and national TV rights. A market multiple based on revenue was applied to normalized EBITDA and then placed in a matrix to derive a set of values. BAC argued that the team deserved a higher multiple due to market demographics, NBA specific characteristics, growth, team management, practice facilities and many other variables.
As would be expected, BAC listed very few considerations that would drive a lower revenue multiple and included things like: 2013 revenue may be non-recurring, team is a tenant in the arena they play in and a possible shift in revenue sharing of TV rights to smaller cities/teams in the future.
The biggest elephant in the room is that all values are calculated ex-players contracts. How do you have a basketball team without basketball payers? How can a reasonable business value be determined without taking into account the cost to produce the value itself?
In addition, BOA only takes into account the total value of the business with no consideration as to the value of the tangible and intangible assets that will have varying degrees of cash flow risk over the estimated time horizon.
For example, are the values of the new TV contracts that BOA estimated at a combined $160 million a sure thing? Is there any chance that they would be more or less than that next year? Is there any risk that they may decline?
Absent an income, cost or other valuation approach to validate the numbers, the value placed on the LA Clippers is based on the greater fool theory.
Conclusion: Shareholders Should Be Pleased With The Investment Bankers at BAC But Should Remain Cautious
At the end of the day, all major league sports franchises trade more on a multiple of billionaire egos then they do on fact-based analysis.
This "ego factor", suggests that a buyer may pay more to acquire a professional sports franchise simply for the prestige of such an enterprise. Any financial voodoo, modeling alchemy or perceived market scarcity are secondary considerations.
BAC investment bankers are sales people, and they pitched a value that would make their client happy. It is up to the buyer to do sufficient due diligence to justify the purchase price and account for the risk of receiving future cash flows.
Over the past 12-months, BAC has been faced with a lot of negative publicity including a fine of $16.6 million related to drug trafficking, allegations of illegally copying software from Tibco, an $800 million fine related to credit card add-ons, manipulation of foreign exchange rates and a $4 billion accounting error. All of that is on top of the $50 billion settlement it paid related to its involvement in the financial crisis.
Overall BAC is still financially powerful, generating $22 billion in revenue last quarter and producing $2.3 billion in net income. However, this was a 43% drop from the same period last year, including $4 billion in additional litigation reserve expenses to account for the multitude of legal woes that are currently facing the bank.
Many of BAC's recent legal issues are to clean up the sins of the past but the undercurrent of mismanagement continues as many of the newer fines/allegations, although smaller in dollar amount, appear just as egregious.
Finally, we are seeing good news for shareholders as BAC bankers appear to be assisting a troubled family become multi billionaires and we concede they appear to have achieved a nice price. For this great result the bank will receive a nice fee.
Despite this one positive sign, we believe BAC shareholders should sell there shares and invest in better run financial institutions.
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.