Which is Better Compensation: Prospects or Draft Picks?

As we near the trade deadline, teams out of contention will look to trade away their players who don't have long until free agency.  The goal is to shed money and receive back prospects who will provide value in future seasons that bring more hope of making the playoffs.  But on the flip side, you have to consider holding on to an upcoming free agent in order to collect draft pick compensation when they sign with another team.

Which is a better strategy, trading a soon-to-be free agent for prospects or letting him walk and collecting the draft picks?  Let's take a look.

Obviously, the prospects vs. draft picks debate hinges on the quality of the prospects and the quality of the draft picks.  Since the former has a wider range of potential value, let's look at taking the draft picks route first.

Route 1: Collecting Draft Picks

As a reminder, if a free agent is offered arbitration, declines, and signs with another team, his old team receives one or two draft picks if the free agent was any good.  For a Type A free agent (in the top 20% of his position group according to a dumb Elias algorithm) the compensation is the signing team's first round pick plus a supplemental pick at the end of the first round.  For a Type B free agent (second quintile of position group) the compensation is just the supplemental pick.

There are two catches to the first round pick changing hands, however.  One, if the signing team is picking in the top half of the first round, they keep that pick and their second round pick changes hands instead.  Two, if a signing team lands multiple Type A free agents, they only have one first round pick to give up and start giving away lower round picks to some teams instead.  That second detail is obviously a loss, but I'd argue the first one is the most damaging to the value of Type A compensation picks.  Take a look at this pick value curve put together by Sky Andrecheck:

via baseballanalysts.com, click to enlarge

Looking at the very left of the graph, the top picks are extremely valuable, and expected value drops quickly after the first ten or so picks, so that the value of a 16th-30th pick is closer in value to the 500th pick than the first pick.

Victor Wang looked at performance by draft pick as compared to signing bonus and salary and found these expected values for each tier of draft pick:

16th-30th Surplus Value: $5.2M (late first round)
31st-45th Surplus Value: $2.6M (supplemental)
46th-60th Surplus Value: $0.8M (early second round)

Type A compensation will include one pick in the middle group plus either one from the first group or one from the third.  If we think that the team signing a free agent is a crapshoot, the expected value of Type A compensation is $2.6M + 1/2 * ($5.2M + $.8M) = $5.6M.  That might not be a fair assumption, however, as the majority of Type A free agents will demand big bucks, only certain teams tend to sign those players, and those teams tend to win more games and draft later in the first round.  But we're not far off as the best possible combination of Type A picks is estimated at just under $8M.  Type B compensation includes one pick in the middle group for an expected return of $2.6M.

Route 2: Trading for Prospects

In order to know the future value of a prospect we need to know which prospect we're talking about.  Trading for Buster Posey is a lot different from trading for me.  Fortunately, Victor Wang has also done extensive research in valuing prospects based on how they're rated by Baseball America and John Sickels.  I've shared this chart many times, and I'll do it again:

There are some flaws to this methodology, mostly tied to any biases in BA's and JS's ratings (beyond hitter vs. pitcher.)  If BA totally ignores defense, for example, a prospect with significant defensive value will be underrated.  But in my opinion, this is by far the best model we have so far. 

People often think there are two other flaws to this research, but I assure you that Wang's dealt with both of them:

• "You didn't account for bust rate -- prospects flame out all the time".  Yes, yes he did account for bust rate.  Wang averaged everyone's performance together in each category above.  Many prospects bust, some become MLB regulars, and a few become stars.  A player who becomes a star will provide $100M+ in excess value.  You don't see numbers nearly that high the table above, because that possibility is countered by the much higher probability of busting.  Simply put, bust rate is in the calculation already.
• "Prospects aren't worth as much because you have to wait many years to collect their value.  Money and production are worth more now."  True.  Wang knew this and built it in to his research:
  

  However, all things being equal, you’d rather have an all-star season now instead of an all-star season four years in the future. To account for this, I used an 8% discount rate and converted a prospect’s average WAB [Win Shares Above Baseline] into a discounted WAB (DWAB).

Putting It All Together

If we realize the average Type A compensation package averages around $5.5M in value, one Grade B hitter would provide the same expected value.  Once that much is included, the rest of the return package's value goes towards acquiring the free-agent-to-be's production itself.  For example, if the Braves are going to trade for Matt Holliday, they don't especially want his free agent picks, but since the A's are going to lose that value in a trade, they need to receive something to offset that loss in addition to offsetting the loss of Holliday's production.  Now, Holliday's production isn't too valuable to the A's the rest of this year, as they're out of contention, but it's extremely valuable to the Braves, who would see a huge increase in playoff probability by replacing Garrett Anderson with Holliday.

So there's really more to this question than we usually realize.  Draft picks vs. prospects should also include "vs. the player's remaining contract value".  That last piece requires looking at salary and production, perhaps with this Trade Value Calculator, and aso an analysis of playoff probability added, which will be different for each team.

Whatever the result of that piece of the analysis, however, a Grade B hitting prospect is the minimum value to offset Type A compensation draft picks.  A Grade B pitcher or someone at the bottom of BA's Top 100 list would be a better haul.  For a Type B draft picks, a young Grade C pitcher or a combination of multiple Grade C hitters and older Grade C pitchers is appropriate.

The short answer is that while free agent compensation picks aren't worth giving away, a package of decent prospects will almost always be more valuable.