Article: Sifting Through the Vladimir Guerrero Jr. Contract Noise

[Bob Ritchie]

The baseball media is mischaracterizing the actual value of contracts with deferred money. Let's get it straight.

How often have you read or heard the following? "The present value of Toronto's offer to Vladimir Guerrero Jr. is X million dollars?" I'm here to tell you that those X million-dollar present value statements are incorrect.

Why should people care if someone has misapplied the present value concept? Consider last week's report that Toronto's offer to Guerrero was close to $500 million, but the present value was closer to $450 million because of deferrals. As I will illustrate, the present value of Toronto's offer was possibly $321.1 million and considerably less than $450 million. Also, Guerrero's ask was likely much less than the reported $500 million present value figure. Therefore, the ensuing discussion among other media members and fans is significantly distorted because media reports include the present value error. Also, as an accountant, I am offended! (No, not really.)

The best way to illustrate the present value error is three-fold. First, explain the present value concept. Second, review MLB's average annual value (AAV) calculation, and third, examine Shohei Ohtani's contract.

Present Value
How often has someone remarked that "a dollar today is worth more than a dollar tomorrow?" This expression is the principle behind the present value financial concept. Present value (PV) is the current value of all future cash flow streams. Consider the table below, courtesy of Initiatewebdevelopment.com.

Suppose the interest rate is 8%, and there is neither credit risk nor income taxes. You would be indifferent if a person offered you $100 four years from now or $73.50 immediately. Why? Because you could invest the $73.50 at an annual compound 8% rate and have $100 in four years [$73.50 x (1+0.08)^4]. You can also find the answer in the present value table. Scroll down the Period column until you find the number 4, then along that row to the 8% column, where you will find the number 0.7350. Multiply $100 by 0.7350 to arrive at $73.50.

The PV model is a valuable analysis tool. However, some people, including media members, misapply the PV concept.

MLB's AAV Calculation
For MLB's Competitive Balance Tax purposes, teams need to determine the AAV of each contract. For a given contract, if no deferrals exist, the calculation is straightforward: divide the total contract value by the term. For example, the AAV of a 10-year, $100-million contract with no deferrals is $10 million.

If a contract has deferrals, the calculation is more complicated. FanGraphs' Jon Becker explained the AAV calculation for the Ohtani contract clearly.

The Ohtani Contract
The sticker price of the Ohtani deal was $700 million over 10 years. However, because of MLB practice, a value of the deferred payments is determined for CBT purposes. Accordingly, the PV of the first $68 million, deferred for 10 years, is $44.1 million. As per MLB practice, the same $44.1 million is used for the other nine deferred payments, and the sum of these deferred amounts is approximately $440.8 million. The same $44.1 million figure is used because the other nine deferred amounts are $68 million and are deferred for 10 years. To arrive at the $460.8 million CBT figure, add the $20 million salary paid during Ohtani's playing time. Therefore, for CBT purposes, the AAV is $46.1 million [($460.8 million) / 10). See Table 1 for the details.

Many people will refer to the $460.8 million as the PV of the Ohtani deal, but that is incorrect. MLB uses the $460.8 million figure for CBT purposes, but it is not the PV of the Ohtani contract. What is the PV?

Recall that the PV definition is the current value of all future streams of cashflows. The PV of all payments ($2 million annually in the first 10 years and $68 million annually in years 11 through 20) is $365.9 million (a 4.43% discount rate). As shown in Table 1, you arrive at the same $365.9 million amount if you calculate the PV of the $460.8 million CBT amount over 10 years. Why 10 years? Because the $460.8 million represents the total if the Dodgers were to pay Ohtani over 10 years. Hence, the PV of Ohtani's deal is $365.9 million, whether you discount the $700 million over 20 years or $460.8 million over 10 years. That constitutes a huge difference. If you're referring to the CBT figure, you're overstating the actual present value of Ohtani's contract by an enormous  $94.9 million.

In summary, be careful when someone states that the PV of a given contract is $X million. As illustrated above, that person probably unknowingly refers to the amount for CBT purposes, not the PV of the cashflows. Let's bring the PV concept to Guerrero and the reported contract demands and offers.

Guerrero Jr.
In the first paragraph, I linked to an MLB Trade Rumors article about a recent report on Guerrero's contract demands. According to the report, Guerrero is requesting a $500-million PV contract. Well, guess what? We have another PV misstatement. If Guerrero wants a 14-year deal with a $500 million PV, then a $707 million contract, paid equally throughout the 14-year term, generates a $500.0 million PV (5% discount rate). Given that Guerrero Jr. has stated that his ask was less than $600 million, and assuming 14 years is his desired term, the reported $500 million PV is another example of a PV misstatement. I suspect the $500 million figure refers to the number used for the CBT calculation.

Another report had Toronto offering a deal close to $500 million. With deferrals, the reported PV was close to $450 million. Yep, PV misstatement alert!  Let's run through an example that approximates Toronto's reported offer. Consider a 14-year, $490-million hypothetical contract. In each of the first seven years, the Blue Jays would defer the payment of $13 million to Guerrero for 14 years. In other words, in Year 1, $13 million is deferred and paid in Year 15, the same amount is deferred in Year 2 and paid in Year 16, and so on. All payments occur over 21 years. The amount for CBT purposes is $445 million, close to the erroneously reported $450 million PV figure. The actual PV of this hypothetical deal is $320.1 million (discounted at 5%).

Contract Talk
I will jump into the Guerrero Jr. contract estimate game, as shown in Table 2 below. Suppose Toronto would pay the $402.5 million over 14 years, with $13-million deferrals, as described in the $490-million example. Table 2's footnotes explain the calculation details.

A contract worth $402.5 million is on the high side because there are some risks to consider. First, the projected performance does not factor in physical decline more than the average age-related deterioration. There are valid concerns regarding Guerrero's durability. Second, the estimate does not reflect a position change from first base to full-time DH, which would reduce his value to the team. Third, the projection assumes consistent year-to-year performance, ignoring the impact of aging. Guerrero's performance has not been consistent. Over the past four seasons, he's put up fWAR totals of 6.3, 3.3, 1.3, and 5.4; none of those figures is within 0.8 WAR of any of the others. If these risks materialize, the projected fWAR total is too high, and accordingly, the money paid by the Blue Jays will be excessive.

Bringing the PV Lesson Home 
Consider Table 3. The first contract is my $402.5-million estimate, and the second is our prior $490-million deal. The third contract exemplifies Guerrero's $500-million PV contract ask. The sticker price is $545 million with the same deferral terms as the other Table 3 contracts.

Let's talk PV. The PV of the $545-million deal is $359 million, higher than my $402.5-million deal (a $258.2-million PV). Put another way, the PV of the $545-million contract is 39% higher than the PV of my proposed deal. The $490-million contract has a PV that's 24% higher than my contract estimate. Given the risks I noted earlier, the PV premiums (39% and 24%) are considerable. If I were Ed Rogers, I would be very uncomfortable with a 14-year, $402.5-million Guerrero Jr. contract.

The Last Word
No matter how one feels about the sticker price of a Guerrero contract, the PV concept is a valuable analysis tool. When used appropriately, it allows the analyst to compare the actual values of contracts with different payment structures. The reader should ignore the typical claims that Guerrero's offer or request has a PV of X. Instead, calculate the correct PV of a given contract or ask an accountant to do it.

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