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August 25, 2005

Lies, Damned Lies

Valuing Draft Picks

by Nate Silver

Three weeks ago, I prepared an analysis of the ill-fated Manny Ramirez-to-the-Mets deal. The workup applied some standard valuation techniques in an attempt to put a price on something that is notoriously difficult to quantify: the value achieved by dumping a big, backloaded contract. That article triggered about as much response as anything I've written in the past year. Most of the responses focused on complementary applications of the framework--those other difficult economic questions that both sabermetrics and traditional analysis have largely avoided.

For example: what is the value of a first-round draft pick? This is an essential thing for a baseball club to have a handle on. Under baseball's compensation rules, a team signing a Type A free agent must sacrifice its first-round draft pick (or its second-round pick, if it picks in the top half of the first round), while a team losing the same free agent acquires that first-round pick, as well as a sandwich pick between the first and second rounds. If the value of these picks is material--above and beyond the signing bonus that would typically be paid to a draft pick--that ought to have a corresponding impact on a team's behavior in the free-agent market.

The economic value of a prospect or a draft pick is in his potential to provide on-field value to his club before he accumulates six years of service time. This period incorporates both his first two years of service--when he has little to no negotiating leverage--and his subsequent four years of service time, when he is subject to arbitration, a process through which teams generally get to pay desirable players well below market price.

After I published my previous article, BP up-and-comer Tom Gorman was kind enough to forward me a paper written by John D. Burger and Stephen J.K. Walters, from Loyola College in Maryland, which quantifies the arbitration discount more precisely. Burger and Walters concluded that:

• A typical, arbitration-eligible player entering his third year of service time is priced at about 31% of his market value;
• An arbitration-eligible player entering his fourth year of service time is priced at 44% of his market value;
• An arbitration-eligible player entering his fifth year of service time is priced at 61% of his market value;
• An arbitration-eligible player entering his sixth year of service time is priced at 64% of his market value.

These figures imply a somewhat larger discount relative to market than the guesstimates I had made before. But my figures weren't based on any evidence, and since a player has limited flexibility under the arbitration system--a player who doesn't like his arbitration result can hold out, but can't sign with another team--it makes sense that the discount is substantial.