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The Ohtani contract: An interesting case study on the intersection of finance, baseball, and star power

MLB: Oakland Athletics at Los Angeles Angels Kiyoshi Mio-USA TODAY Sports

Disclaimer: The details of the contract are still coming out, I will make changes to the article if necessary

The Shohei Ohtani signing by the Dodgers is one of the most significant events to happen in baseball in quite some time, not only in terms of the overall size of the signing but the sophistication of the deal as well. What is also interesting about the deal is that it suggests that the Dodgers and Ohtani are not sanguine about the Japanese superstar returning to the pitcher's mound long-term.

At first glance, the Ohtani deal is almost double the next highest deal; however, this isn’t telling the whole story. 680 out of the 700 million dollar contract will be deferred to 2034 and beyond. Everyone who has taken a college-level accounting class has a rudimentary understanding of the time value of money. One of the primary factors for determining the future value of money is interest rates.

The benchmark most corporations and banks use for longer-duration interest rates is the 10-year treasury note, which is currently yielding 4.15%. Think of the treasury note as the floor for all other investments. If the 10-year note is under 2%, which it was for much of Covid, then risky investments, like Bitcoin, will look more attractive because the safest asset doesn’t yield very much. The opposite is also true; if the 10-year yields over 10%, as it did in the early 80’s, then all other assets will look less desirable. Thus, treasury securities are a good input for interest rates in any time value of money calculation.

The formula for present value is as follows:

PV = FV/(1 + i) ^n

i= the interest rate

n= the number of periods

Since the Dodgers will not be paying out all of Ohtani’s contract in 10 years, it is more appropriate to use an average of the yield for the 10-year and 20-year treasury bonds, which is about 4.3%.

Ten years is the number periods.

If we plug in these variables, we get an average annual present value of the contract at approximately $44 million, not including the 2 million a year that will not be deferred. What makes the contract slightly more complicated is that although there are mechanisms to lock in a specified interest rate (futures contacts and interest rate swaps), there is no way to predict the present value of money for the whole contract because we don’t know what future interest rates will be.

To the Guggenheim group, the firm that owns the LA Dodgers, this is an incredible deal financially. According to Bob Nightengale of USA Today, the Dodgers expect Ohtani to be worth around $50 million annually in marketing and advertising alone, not to mention the amount of money Ohtani is worth in Wins Above Replacement. Simply put, Ohtani loaned the Dodgers 46 million a year with a similar interest rate that the federal government enjoys. Furthermore, unlike a traditional bond or mortgage, the borrower does not have to make payments for 10 years. In return for a low-interest loan, the Guggenheim group gets the increased cash flows that Ohtani will inevitably bring in.

Many fans will wonder why Jim Crane or their respective owner do not make similar moves. However, most owners do not have the assets to protect themselves in this transaction.

In order to hedge this exchange, the Guggenheim group will probably purchase 10-year bonds with varying degrees of risk. AAA and AA corporate bonds, which are almost as safe as treasuries, yield around 5%, meaning that the Dodgers may even make a slight profit off of the transaction.

If interest rates fall, which may happen, then Guggenheim will have to purchase more bonds yearly to cover the contract. As previously stated, there are a plethora of ways the team can lock in and/or hedge their rates, but that is beside the point.

The Guggenheim group has about 300 billion in assets under management, and they will be able to pay Ohtani every year regardless of what happens to treasury yields or their revenues. Jim Crane and the Stros do not have the same luxury.

Jim Crane is “only” worth 1.6 billion dollars and it is unlikely that he has the necessary cash flow to purchase approximately 46 million a year in bonds annually. Which means that he will have to, at least partially, make payment out of future revenues. This is a risky bet.

MLB annual revenues have increased by approximately 290% since 2001, compared to a 65% increase in general consumer prices. However, it is possible that revenues will be stagnant. The rise of streaming and the decline of cable may result in decreased TV revenues going forward. Secondly, while the median age for ticket buyers dropped to 43 in 2023, this is still significantly higher than the other major sports, and it remains to be seen whether this is a long-term trend or an anomaly.

Betting on increased revenues to pay out a mega contract like Ohtani’s is a risk not worth taking for Owners like Jim Crane. Unlike the Guggenheim group, which can take riskier bets on baseball because its firm is invested in many other asset classes, Crane has to be more cautious because baseball makes up the majority of his business operations.

This deal also says a lot about how the market views Ohtani’s future production. One win above replacement is generally valued at ten million a year in the free-agent market. In bigger deals, this money will usually get spread out over a longer duration. When the Yankees gave Gerrit Cole a 9 year, 324 million, they were not projecting him to be worth 3.6 WAR every year. They were betting he would produce at least 32 WAR over the life of the contract, as the production would probably not be evenly distributed.

As previously stated, the PV of Ohtani’s salary is approximately 46 million a year, which is also what the MLB is charging the Dodgers toward their luxury cap total. Over four full seasons, Ohtani has produced over 30 WAR; at age 29, Ohtani likely still has several peak years ahead. However, given the implied projection of 46 career wins, it is likely that the Dodgers are ok with him never pitching again. Ohtani will already not be pitching in 2024, and if he and the free agent market projected that he was capable of pitching again, he would be making significantly more than $46 million a year. Bryce Harper is an imperfect, but decent comparison to Ohtani, if he didn’t pitch. Bryce Harper also has limited defensive utility and a contract that ends in his age-39 season. Harper’s average annual salary is $25 million, which is 20 million less than the PV of Ohtani’s.

Obviously, Ohtani offers a lot more in marketing and revenue than Harper, that is no slight to Harper; Ohtani is just a once-in-a-generation athlete. As previously stated, Ohtani’s revenue outside the value he brings in extra wins is significant. If Ohtani continues to do well, there is a good chance that he will make a Dodgers fan out of all of Japan.

If Shohei was able to continue to pitch at an elite level, his contract would be much more lucrative than what he signed for.

Conclusion:

The corporatization of pro sports has been a trend for over ten years. This trend will continue, but do not expect teams to be able to make many moves like this.

Ohtani is a one-of-a-kind athlete, and due to his endorsement opportunities, he has the option of deferring a bulk of his salary while still making tens of millions a year.

Secondly, the Dodgers are one of the only teams in the league that has the balance sheet to make a move like this. Most teams will not have the financial capital or risk tolerance to put this big of a financial obligation on their balance sheet.

As an Astros fan, it makes me nervous to go see how ultra-large market teams are using their financial prowess to make smart deals. However, at the end of the day, the core of every team will continue to be how they evaluate and develop young talent. For now, it looks like the Astros have the tools to be competitive in that area for years to come.