will increase, and that it will come, not only from States and cities,
but from corporations. Much of the work done in the past has not been
described in the publications of scientific societies; much very
valuable work has secured only partial notice through reports of
litigation; and it is undoubtedly true that the most complete and full
discussions of the principles of valuation have been in the form of
expert evidence before the Courts, and are buried in the mass of
unprinted records of testimony.
REVIEW OF SOME METHODS OF VALUATION, AND SOME OF THE CRITICISMS
ON THE MICHIGAN APPRAISAL.
Much of the available literature on the subject of valuations is in the
form of papers descriptive of water-works appraisals and arbitrations,
many of which have been made, and a few of which have been the subject
of valuable papers and discussions before learned societies.
Before the American Water-Works Association, D. W. Mead and J. W.
Alvord, Members, Am. Soc. C. E., have presented papers[12] which have
been quite fully discussed. The chief point of interest in these papers
is the treatment of the intangible element termed "going value." Mr.
Alvord advances the argument that, after the determination of physical
present value, there should be added, to determine the fair value, two
non-physical elements: the "going" or "business" value, and the
franchise value. The first element is defined as that special value
which is:
"Built up ... by the energy, perseverance and solicitation of the
officers in charge, as distinct from the inert plant itself, ...
* * * * *
"The element of 'going value' has been before described as the element
of growth in the plant irrespective of its physical condition. It is
comparable somewhat to that indefinable quality known in other lines of
business as 'Good Will'. Nevertheless it is something more than good
will in water works business, as it represents what might be more aptly
described as 'connected good will', that is to say, the acquisition of
customers who have invested considerable sums in actually connecting
their premises with the plant of the company, and provided appliances
for the use of the water which it can deliver."
The method advocated by Mr. Alvord as the most rational one for
computing this value is described as follows:
"It is assumed that a new plant will be constructed, the inception of
which is coincident with the data of arbitration. Such new plant is to
be of an equal capacity with the older plant under consideration, and a
due allowance of time in which to construct this new plant, and the
necessary capital to be invested in it from time to time is estimated.
At the completion of this new imaginary plant, it is assumed that it
commences to obtain business in that community from those who are not
previously accustomed to the free use of public water, except in a
general way; that it is to require the business ability and consequent
increase in number of customers which the earlier and older plant went
through within the early years of its existence. An assumption of the
amount of business thus created for each year for a period of years in
advance is carefully computed and estimated by the board of arbitration.
The losses of interest upon capital invested are duly fixed, as well as
the first absence and later addition of revenue from hydrant rentals,
and a table is prepared showing each year, the total business developed
and the total losses, if any. After this is completed a forecast is made
of the business of the older works for the same period of time in the
future that it takes the business of the new works to equal the business
of the old works. If the business of the old works is found to be a
growing one it will be a longer period that the new works will require
to overtake it than will be the case if the business of the older works
is stationary or decreasing. In general, the differences which might be
called the debits and credits of this new imaginary plant and the debits
and credits of the older working plant are reduced to their present
worth at the time of appraisement, and an estimate is made up which will
adequately represent the financial advantage which the old works
(already fully equipped and in running order and having a large number
of profitable customers) will have over the new works, where everything
must be built and customers secured.
"It is necessary in making this supposititious estimate of the new plant
to consider it in no way a competitor of the older works; there is not
supposed to be competition between the new and the old, but it is left
to the experience of the board of arbitration to consider how long it
would take the new company to build new works, and build up business for
the new works, until they have overtaken the business of the old company
should it continue to occupy the same territory."
Mr. Alvord's description of his method has been quoted fully, as it is
an interesting one and has been often used. It is open to the very
decided objection that it is purely theoretical, a rational method of
computation, perhaps, but based on assumption throughout. It may be said
to be a method which is within the field of pure speculation. Mr.
Alvord, himself, says that where experience in financial matters and the
financial management of water-works is not brought into the valuation,
there is usually to be found guesses of the wildest character. Professor
Mead, in discussing Mr. Alvord's method and agreeing that it is
consistent and logical, says:
"The method is by no means an exact one, and must necessarily lead to a
very great divergence in opinions as to the 'going value,' in accordance
with the assumptions on which it is based.... Its very logic is an
element of danger, for if clearly presented from a biased standpoint to
one previously unacquainted with its application, and if accepted
without careful analyses it may lead to very unjust conclusions. If
used, however, carefully and conscientiously with the desire to do
justice to all concerned, it is a valuable method of estimating going
value, and the only logical one with which the speaker is familiar."
In addition to the element of going or business value, Mr. Alvord
considers the franchise value, and presents two methods for its
determination:
_First._—The physical value, depreciation, and going value are entirely
neglected, and the entire valuation is fixed on the basis of its earning
power throughout the remaining life of the franchise and its probable
sale value.
The probable net revenue for each year of franchise life must be
estimated and capitalized at a sum, which, if put at interest, would pay
such yearly revenue and extinguish itself at the end of the franchise
period. To this must be added the physical value of the plant at the end
of the franchise period.
_Second._—The cost of reproduction, depreciation, and present physical
value are ascertained, and the going value computed. Then it is
determined whether or not the net revenue is paying interest on a
capitalized value greater than that indicated by the sum of the physical
and business values. If such capitalized figure is less than this
combined value, there is, of course, no franchise value; if it is more,
there is a franchise value which should be determined by estimating, for
the remaining years of the franchise, the excess income over and above
that necessary to cancel all obligations (including interest on the
physical and business values), and the reduction of these several sums
to a basis of present worth.
A number of other articles and papers are listed in the Appendix. Many
of these are of great value and are well worth careful perusal, but they
offer no definite plan of valuation. Inasmuch as the general principles
involved in the valuation of a water-works plant and a railroad plant
are similar, it is advisable, in any exhaustive study of the subject, to
review the articles descriptive of water-works valuation, and it is a
matter of regret that greater consideration cannot be here given to some
of the points raised by such engineers as George H. Benzenberg,
Past-President, Am. Soc. C. E., Kenneth Allen, Arthur L. Adams, Emil
Kuichling, Members, Am. Soc. C. E., and others in their various papers
and discussions of this subject.
The _Railway Age_, the _Railroad Gazette_, the _Railroad Age Gazette_,
and the _Railway Age Gazette_ contain many editorials and articles on
the valuation of railroad properties. These are written mainly from the
standpoint of the railway official, and present many matters of interest
which are worthy of study prior to undertaking a large appraisal. One
series of articles in the _Railway Age Gazette_[13] is a most masterly
argument, and it is to be regretted that the author has not disclosed
his identity.
The Michigan valuation has been discussed in two papers by Mr. Charles
Hansel, whose connection with the work, as a member of the Board of
Review, gave him probably a more intimate knowledge of it than any one
else, not connected with the actual working organization, who has
undertaken to review the work. His first paper, published in 1901,[14]
entitled, "What is the Value of a Railroad for Purposes of Taxation?" is
a discussion of the work of Professors Cooley and Adams, written while
the subject was fresh in his mind. His second paper, an able argument
for a Government valuation, appeared in the _North American Review_ in
1907. The one point to which special attention is drawn is Mr. Hansel's
astonishing misconception of Professor Adams' plan of work. This
misleading statement appears in the first paper and is reiterated in the
second. It is of such a character that to pass it unchallenged would be
doing great injustice to Professor Adams. He states Professor Adams'
plan as follows: Capitalize net earnings and add to the present value of
the physical appraisal as found by Professor Cooley.
"The result would be that in case the present value per mile as
determined by Professor Cooley is found to be $15,000, and the net
earnings by Professor Adams are found to be $1,000, this capitalized at
5 per cent. would equal $20,000, and added to the present value would
make $35,000, which would be the sum upon which taxes were to be levied.
In other words, if the company actually earns $1,000 it increases its
value for purposes of taxation 20 times that amount. If, however,
instead of having a net earning of $1,000 it spends that sum in
improving the property, it has only increased its taxable property by
$1,000."
This statement is not only inaccurate, but involves the other error of
assuming that the appraisal figure was to be used for taxation. It was
not. It was merely information to aid the legislature in framing new
taxation laws. The chief error, however, is in assuming that Professor
Adams added the value of the property, as determined by a capitalization
of net earnings (which _per se_ is a well-recognized method of
valuation), to the value of the physical property. This error probably
is due to the flood of criticism which at the time was aimed at any form
of non-physical valuation.
Professor Adams finds the net earning in Mr. Hansel's example to be
$1,000 per mile. From this, in the method actually used, he deducts an
annuity for the support of invested capital, which he assumes to be the
present value found by Professor Cooley. In the example given by Mr.
Hansel he would deduct 4% on $15,000, or $600 per mile, leaving $400 per
mile as surplus, or the earnings due to non-physical elements of value.
This, capitalized at 5%, would give $8,000 per mile, which, added to
Professor Cooley's figure of Present Value, would make $23,000 per mile,
instead of $35,000, as stated by Mr. Hansel.
The most recent criticism of the Michigan valuation work was in an
address[15] before the New York Traffic Club in January, 1909, by Mr. W.
H. Williams, Third Vice-President of the Delaware and Hudson Company.
This address is devoted to an attack, not only on the work of the
Michigan appraisal, but on Professor Adams' work and on the propriety of
valuation work being undertaken for any reason. The arguments advanced
in this address are such that a discussion of them becomes almost
necessary in any complete review of the Michigan work, and it contains
so many statements which are erroneous that it would hardly be
permissible to pass them without comment. The manifest impatience with
all forms of governmental interference with corporations, which so often
characterizes the utterances of prominent railway officials, appears in
this paper to a marked degree. After stating that the present agitation
for a physical valuation appears to be the result of a misconception, on
the part of the Interstate Commerce Commission, of Section 20 of the Act
to Regulate Commerce, and quoting Professor Adams' suggestion of an
inquiry, he says:
"Subsequently, the desire of Governor Pingree to find a means of
increasing railway taxation in Michigan gave Professor Adams an
opportunity to experiment with his project within the limits of that
State."
This is a direct imputation of an improper motive, not only to Governor
Pingree, but to Professor Adams. As stated elsewhere, the investigation
was to determine whether the railroads were paying taxes on the same
basis of valuation as other property in the State—an absolutely proper
proceeding. Professor Adams was associated with the Michigan appraisal,
but had no connection whatever with the "physical valuation," to which
such objection is taken, and his appointment was made after the work of
physical valuation had been fully outlined and was well under way.
The opening statement is followed by a brief _résumé_ of the
recommendations of the Interstate Commerce Commission and President
Roosevelt, and of bills introduced in Congress, also by quotations from
Bulletin 21, describing the methods of valuation used in Michigan and a
showing that practically a similar basis was used in other States. Mr.
Williams then summarizes his objections to the Michigan work:
"(1) No allowance is made for discount on securities sold.
"Discount is a partial capitalization of the commercial risk had in
making the investment, and it increases or decreases in proportion to
the probability of the earning power of money under existing conditions.
Not only is this practice justified by long-established commercial
usage, but also by judicial determination."
The correctness of this position cannot be conceded on any grounds of
economics or accountancy. It is answered conclusively in an article,[16]
elsewhere referred to, as follows:
"There is considerable diversity of opinion as regards the proper
treatment of discount on securities sold. There is a distinction between
bonds, representing corporate indebtedness and having a definite
limitation as to the time of their redemption, and share capital,
representing ownership and which as a rule is irredeemable. In relation
to the former there can be but one tenable view. If a company can market
its 50-year 4 per cent. bonds at 90 per cent. of par, it means that the
company's credit is on a 4½ per cent. basis; that it could market a like
security paying 4½ per cent. at par. If it elects to issue at the lower
rate it is merely sacrificing principal for the sake of a reduction in
the annual interest charge; in other words, it is pre-paying interest
which would accrue during the life of the issue. If $10,000,000 par
value were issued at 90 per cent., the discount would amount to
$1,000,000, and the saving in interest to $50,000 per year, or
$2,500,000 in 50 years. Obviously the company cannot claim the privilege
of capitalizing the discount, while thereby availing itself of the
reduction in interest. If such a course were legitimate in the case of a
5 or 10 per cent. discount, it would be equally so if the discount were
50 or 75 per cent., when the absurdity of the proposition would be
perfectly apparent. The somewhat general practice of prorating the
discount, as a charge against revenues, over the term of the
obligation's existence is sound; but this should be done, not in equal
installments, but on the basis of the appreciated value of the bond as
it approaches par at maturity. There is no apparent objection to
charging discount of this nature in a lump sum against an accumulated
surplus. The capitalization of discount on stocks, involving as it does
the introduction of fictitious values in capital assets, is wholly
indefensible."
The writer has failed to note any particular "judicial determination"
which approves of the charge of any such item to capital account.
"(2) The interest during construction (3 per cent.) is less than a fair
and reasonable return on the investment."
The amount actually paid out for interest on money used during the
period of construction will vary, of course, depending on the time of
construction and the way in which payments on construction materials are
made. On the basis of a rate of 6% per annum and construction lasting
one year, only a very small portion of the construction cost will pay
6%, while the great items of rails, buildings, motive power, and
equipment will be put into the work from 90 days to 10 months after the
commencement of work, and will actually bear but little interest. In the
Michigan appraisal the assumption was made that all work must be
replaced in one year, and that on long roads partial operation would
commence as various sections of the line were completed; and 3% was
agreed on as a fair average, perhaps having in mind Governor Pingree's
"desire to increase railway taxation." Some assumption must be made.
This one, that long roads, covering several years of construction work,
are in Michigan put in partial operation as soon as built, is not
unreasonable. Such an assumption clearly would not be proper in the case
of long lines crossing mountains, or involving such a class of
construction as to make it impossible to complete the property short of
two or three years; and, in any such cases, the interest charge should
be made sufficient to cover.
"(3) No allowance is made for working capital with which to carry on the
business."
All the appraisals of physical property have been made on the basis of
securing a figure representing the cost of reconstructing the property
in the condition in which it existed on the date of the appraisal,
including only items properly chargeable to capital, cost of road, and
equipment. This is not such an item. The writer is of the opinion,
however, that it is a proper one to determine and include in any report.
"(4) No allowance is made for wear and tear of material during the
period of construction. Assuming eight years to be the life of a tie,
and three years the period of construction, a substantial percentage of
the period of usefulness is over before the road is in operation. The
use of the rails before the track is put in proper line and surface
hastens the time when they must be removed."
This deterioration is a necessary incident to any construction work. It
has not been customary or usual to take account of it. To add to the
amount capitalized on account of this item would be manifestly improper.
The only way in which this could be cared for would be in an adjustment
of the depreciation reserve when raised to cover that which takes place
during the construction period. This reserve, later in the address, is
objected to by Mr. Williams as improper accounting:
"(5) No allowance has been made for impact and adaptation. After the
line is placed in operation, each fill will sink 1 ft. for every 10 ft.
of height. The slope of cuts must be increased to prevent landslides and
washouts. The ballast will pound into the roadbed, necessitating
additional ballast to secure a standard cross-section."
Part of this objection is covered by the item, "Appreciation of
Roadbed," discussed elsewhere. This, perhaps, is a proper item, but a
comparatively small one. One of the examples cited is clearly
maintenance. This objection is largely covered in the Michigan work by
the contingency item.
"(6) A uniform price for earthwork was used, thus ignoring the varying
character of soil and length of haul."
This is erroneous. On the Michigan appraisal prices were used for earth,
loose rock, and solid rock. There is practically no classification in
the Southern Peninsula of Michigan, or, in fact, on 90% of the mileage
of the State. The price used was not much out of the way when considered
as a fair average for the territory. The same was apparently true of
other appraisals. It would not be a proper figure to use in an estimate
based on 1909 prices, which are materially greater than those obtaining
in 1890-1900.
"(7) A uniform price list for all materials was used, thus ignoring the
source of supply and cost of delivery to point of use."
This, again, is not true. Differences were made between the Upper and
Lower Peninsulas; and an exhaustive study was made of rates to different
sections. It is believed that the prices adopted took all these points
fully into consideration. It is true that no effort was made to use
different unit prices as between counties, but, in a number of cases,
differences in prices were made for different sections of the State,
where either local conditions as to production of materials, or traffic
rates, seemed to warrant.
"(8) No allowance was made for interference with work on account of
labor troubles, condition of the weather, etc., which would vary
materially in the different counties of the same state."
True. Nor is such allowance ever made in actual construction, beyond the
contingency item. Such items are a frequent source of annoyance, delay,
and sometimes of expense, but an expense difficult to separate and set
up, and clearly belonging to contingencies.
"(9) No allowance is made for carrying charges until such time as the
road was placed on a revenue basis."
True; and such item is not a part of a physical appraisal.
The foregoing nine points are classed as "among other things" open to
criticism. The next two quoted paragraphs are introduced to indicate the
"other things" as they appear. These are mainly non-physical or
intangible elements of value, which, under the method of Professor
Adams, are treated _en bloc_, and which, from their nature, it would be
impossible to set out and value separately; therefore, no effort is made
to answer them point by point, further than to say in general that, if
there is any value attaching to these items, it was presumed to have
been disclosed by the method of Professor Adams, and to suggest further
that had Professors Cooley and Adams had such an advocate of intangible
values ten years ago, their labors would have been lightened, as all
arguments by railway officials at that time were against the use of any
such elements of value in an appraisal.
"No consideration has been given to the leasehold interests....
Therefore it will be seen there remains to be determined many questions
vitally affecting the value of the property without regard to its value
as a 'going concern.'
"There should be no difference in the basis of arriving at the value, as
a 'going concern,' of the property of a railway and any industrial
establishment, nor should there be any difference in the basis of
valuation for taxation [exactly what Governor Pingree maintained] or
other purposes. There is common to both the value due to location, good
will, etc."
While the remainder of the address in question contains no specific
criticisms of methods of valuation, it does go into a discussion of
sundry legal decisions; and conclusions are drawn quite at variance with
those set forth elsewhere in this paper. The thing most noticeable in
the entire address is the lack of a proper spirit of fairness, an
apparent inability to state fully and fairly the position of the men
whose views are being opposed, and an undue emphasis in quoting some
public official whose views coincide for the time being with the
theories which are being advocated. The fact that Mr. Williams quotes
from an address of Hon. Robert H. Shields, President of the Michigan Tax
Commission, a statement criticising the work of Professors Cooley and
Adams, illustrates the latter point.