franchise can be stated. It is valuable: (1) because it authorizes
the gainful use of private property in a particular manner; (2)
because once obtained it is often difficult or impossible to get
another like it; (3) because it may be used to injure or hinder
another enterprise, although itself conferring or securing nothing
of value.
"The third method of statement has been accurately, though
colloquially, described as a 'nuisance value,' and is so obviously
illegitimate as to require no discussion. The second method of
statement, when carefully considered, asserts that because the
sovereign has deemed it advisable to entrust a public work to one
citizen or a body of citizens such quasi monopolistic grant confers
the right to charge for the service more than would be just or
lawful were the occupation open to all. Nor does it change the truth
of the last statement that the difficulty of procuring franchises
produces, and long has produced, a traffic in them. On every private
sale of franchise property, the price paid is so much money lost to
the public by official incompetence or worse, and such sale can
confer on the vendee no right to compel the consumer to repay him a
price that should have been paid to the State. For these reasons, I
believe that on principle a franchise should be held to have no
value except that arising from its use as a shield to protect those
investing their property on the faith thereof, and that, it renders
fruitful, it possesses no more economic value for the investor than
does an actual shield possess fighting value, apart from the soldier
who bears it."
It will not do to leave this decision without calling attention to the
fact that the foregoing quotations are but argument advanced by the
Court, and that he found a franchise value, following the reasoning of
the Supreme Court in cases cited heretofore, and other cases, and upon
the doctrine that:
"Private citizens may acquire vested property rights through a
series of even erroneous decisions; rights so firmly vested that it
becomes unconstitutional for the court which persisted in error
suddenly to rectify its mistakes to the detriment of those who had
securely rested upon the decisions sought to be invalidated."
After citing numerous cases, and considering methods of valuing
franchises, the Court says:
"I think it obvious, as I have endeavored heretofore to point out,
that either for the purpose of condemnation or regulation the value
of a franchise depends wholly upon what is earned under it and I
believe the best way of finding out how much a franchise, separately
considered, is worth, is to ascertain what those persons desirous of
continuing operation under it consider it to be worth. In a
corporation whose stock is freely bought and sold, such value is
measured by the success attending the sale of stock based entirely
upon capitalization of the franchise; yet the value of stock issued
only in consideration of the franchise is obviously dependent on
earnings after the stock based on tangible property has received a
satisfactory dividend * * * yet it will always be true that, unless
the whole net return, compared with the value of tangibles, is above
a satisfactory return on tangible investment alone, the addition of
stock issued for franchise will be regarded as 'water,' and detract
from the value of the entire issue, and I think this conclusive
proof that value on a franchise depends wholly on what actual
investment can earn."
In this particular instance stock to the amount of $7,781,000 had been
issued in 1884 and divided among stockholders without any consideration,
which stock represented the company's own valuation of its franchise at
that date. The Court, in fixing a value, held that it would be proper to
increase it proportionately to the increase in tangible property; this
he did, fixing the franchise value at more than $12,000,000. The Supreme
Court of the United States, in disposing of this, says (212 U. S., 47):
"But although the state ought for these reasons [applicable to this
case—not general], to be bound to recognize the value agreed upon in
1884 as part of the property upon which a reasonable return can be
demanded, we do not think an increase in that valuation ought to be
allowed upon the theory suggested by the Court below. Because the
amount of gas supplied has increased to the extent stated, and the
other and tangible property of the corporations has increased so
largely in value, is not, as it seems to us, any reason for
attributing a like proportional increase in the value of the
franchises. Real estate may have increased in value very largely, as
also the personal property, without any necessary increase in the
value of the franchises. Its past value was founded upon the
opportunity of obtaining these enormous and excessive returns upon
the property of the company, without legislative interference with
the price for the supply of gas, but that immunity for the future
was, of course, uncertain, and the moment it ceased and the
legislature reduced the earnings to a reasonable sum, the great
value of the franchises would be at once and unfavorably affected,
but how much so it is not possible for us to see. The value would
most certainly not increase."
The Court did not concur in the increase of the franchise value, and, in
dismissing this subject, says:
"What has been said herein regarding the value of the franchises in
this case has been necessarily founded upon its own peculiar facts,
and the decision can form no precedent in regard to the valuation of
franchises generally where the facts are not similar to those in the
case before us."
It appears, then, from this, the latest case, that:
_1._—The view of the lower Court that a franchise or intangible value is
not separable, and that if there be a value it must be determined from
the earnings, is concurred in by the Supreme Court.
_2._—That the arbitrary increase of franchise value, by the lower Court,
proportional to the normal increase of the physical property, is not
concurred in.
_3._—Inferentially, it appears that the acquiescence of the State in the
franchise value of 1884 is the main reason for permitting that value to
stand, and it would seem to follow, from the reasoning of the Court,
that it is very questionable whether any franchise or intangible value
based on excessive rates should be allowed to stand.
Another view of franchise values, as stated by George H. Benzenberg,
Past-President, Am. Soc. C. E., in discussing water-works franchises, is
as follows:
"Some contend that a franchise is simply and purely a privilege
given by the municipality to a water company to utilize the streets
for the purpose of laying a system of pipes through which it may
distribute and deliver water. It is not a license to do business,
but a privilege to use public streets, alleys, and grounds. * * * If
that interpretation is the proper one, the value of the franchise,
if the property is to be purchased by a municipality, is
comparatively nothing. If the property is to be purchased by another
company, it represents all of the great value that such franchise
possesses to the original holder, together with all the privilege it
confers; but in the event it is purchased by the city, it is
dispossessed of that certain element of value, and I think for that
reason it is stipulated in many of the ordinances that no value
shall be placed on the franchise by appraisers."
In the paragraph just quoted, it is evident that the term "franchise" is
used in a restricted sense, and refers to the ordinance or contract from
a municipal corporation granting the right to operate on specific terms,
rather than the broad use of the word as indicating all rights derived
from general laws or special contracts or grants. The point, however, is
applicable to the case of any corporation occupying public ground.
It is believed that enough argument has been adduced to show that any
attempt to give separate value to the different elements that enter into
the intangible value of a property is a very risky proceeding on the
part of appraisers, and to support further the contention that, as a
business proposition, the value of any property depends on its earnings;
that the franchise simply protects the owners of the property in their
enjoyment of those earnings; that the value of the franchise merges in
the "fair value" of the property, and that the franchise can have no
special value of itself unless the earnings of the property are in
excess of a usual and fair rate on the actual investment. In case there
are surplus earnings, they measure and determine not only the value of
the franchise, but also the value of all other non-physical elements. If
this be true, any readjustment of rates, any restriction of operations,
or other form of legislative control which would unfavorably and
violently affect earnings, is bound to hold down franchise or
non-physical values; as it would not seem possible to read into the
various decisions any intention on the part of the Court to base the
right to demand fair return on anything but the "fair value of the
property being used."
The writer, therefore, reaches the following conclusions regarding
non-physical values:
_1._—That all the different non-physical elements of value are
inseparable.
_2._—That in the case of very many properties, no non-physical value can
attach, and in many cases this value will be a negative or subtractive
quantity.
_3._—That in the case of properties located so as to secure either a
monopoly of business in a congested territory, or in which the
construction, location, strategic position, or economic excellence of
design, is such that, on a schedule of rates which is fair and
reasonable for competitors less advantageously situated, an earning is
secured which is in excess of usual returns, a non-physical value of
considerable magnitude may very properly be assigned.
_4._—That, for the computation of non-physical values, the income
account of the property under consideration affords the only legitimate
basis, but even then consideration must be given to duration of
franchise, reasonableness of rates, and other modifying conditions, and
also, possibly, the purpose for which the appraisal is made may
determine whether or not a non-physical value may be used. The language
of the Court in the Knoxville and Omaha cases apparently leaves this a
very open question.
This brings us substantially to the conclusion reached by Professor
Adams in 1900, and a careful study of the method laid down by him shows
nothing that cannot be accepted as fair and reasonable. His plan should
be extended so as to cover subtractive values or the case of properties
showing a deficit.
This method has the merit of being based on the actual earnings and
expenses of the company under investigation and on the value of the
physical property as already computed. It does not introduce a mass of
purely supposititious figures, nor depend on hypothesis. The proposition
is simply this: If a property earns only its operating expenses,
including therein proper depreciation reserves, taxes, and such a
percentage on its actual invested capital as could be earned by that
capital if invested in good non-taxable bonds or other like security, it
is worth no more than its physical property is worth. If it earns more
than that, it is due to the franchise, going concern, or other
intangible elements of value, and, to determine that value, capitalize
the surplus.
It takes several years for a property to reach its normal earning
capacity after construction is completed, and, in the investigation of a
property of comparatively recent construction, where the gross and net
earnings show a steady annual increase, the application of a negative or
subtractive value should be made with great caution; but where the
earnings have been fairly uniform and stationary for a period of years,
and the property does not earn a sufficient sum to care for depreciation
and annuity, it is clear that the value as an earning investment is less
than the determined physical value, and that the physical valuation
should be reduced by some amount to arrive at the "fair value."
The Courts hold that public service corporations are entitled to earn:
(_a_) Operating expenses,
(_b_) Expenses of maintenance and running repair,
(_c_) Taxes,
(_d_) A sinking fund from earnings to cover depreciation and
obsolescence, and
(_e_) A reasonable profit on the fair value of the property.
An investigation of non-physical values should then include an analysis
of operating expenses, to determine that additions and betterments to
property are not included therein.
The general practice of corporations in the past has been to ignore any
reserve to cover depreciation and obsolescence. If, at the beginning of
operations of any property, such a sum should be annually set aside out
of earnings as should, when invested as a sinking fund, maintain the
integrity of the investment, then this amortization fund at any period,
plus the depreciated value of the physical property, should equal the
amount of the total capital actually invested in the property. In most
cases this has not been done, and the Supreme Court in the Knoxville
Water Case holds that, by reason of the failure to create such a fund,
whether due to carelessness, excessive dividends, or other cause, the
company must lose the amount of capital represented by the depreciation
that has taken place. In making a computation of intangible values, it
is certainly proper to consider the income account as averaged over a
period of years, to avoid violent fluctuations of gross or net earnings,
and a depreciation reserve should be determined for such years, as it
cannot be claimed that, unless such an amortization fund is earned, in
addition to other operating expenses and taxes, there is any
non-physical value.
Professor Adams covered the depreciation in the Michigan work in the 4%
annuity which was deducted before non-physical values were computed. The
writer is inclined to go a step farther than Professor Adams, and hold
that, before any intangible values can be attached to the property, it
should earn not only all operating expenses, taxes, and reserve for
depreciation, but also interest on the actual investment equivalent to
the return that would be had were the money invested in a non-taxable
bond, say 4%, and that any earnings in excess of such a sum might be
termed properly "earnings on franchise," or intangible values.
On this basis, then, a rule would be formulated, being that of Professor
Adams, with some modifications:
_1._—Deduct from gross earnings from operation the aggregate of
operating expenses, including in operating expenses an annual sinking
fund to amortize the depreciation and obsolescence, and the remainder
may be termed "income from operation."
_2._—To this income from operation add income from investment, giving
"total income," which represents the amount at the disposal of the
corporation for the support of its capital and for the determination of
its annual surplus.
_3._—From "total income," deduct taxes, rents paid for lease of operated
property (provided such property is not included in the appraisal), and
improvements chargeable to income. The remainder represents the income
after all charges against operation of property, and maintenance of the
integrity of the capital investment have been cared for.
_4._—From this remainder (_3_) deduct such a percentage of the value of
the physical property (representing invested capital) as would equal the
income of that capital if invested in government or other non-taxable
bonds. The remainder would represent surplus, which, capitalized at a
proper rate, would equal the value of intangible or non-physical
properties, which is to be added to the appraised value of the "physical
property."
_5._—If, instead of a surplus, a deficit occurs, a careful study of all
the conditions surrounding the operations of the property should be
made, and, if there be no reasonable expectation of increase of
earnings, or other modifying conditions, a proper figure, based on the
average deficit, should be determined, and, as a negative intangible
value, deducted from the value of the physical property.
_6._—In the determination of rates, to be used in computing income and
for capitalizing surplus or deficit, the greatest of care must be
exercised to adopt such figures as will be proper and absolutely just.
CONCLUSION.
The subject of valuation is so appallingly great that, notwithstanding
the length this paper has reached, many points have not been covered.
No discussion of the method of valuation by capitalization of net
earnings, which is practically that adopted by Professor Adams in his
commercial valuation, has been attempted; nor has any attempt been made
to describe the stock and bond method. Neither method is adaptable to
the requirements of any public appraisal.
The so-called cash investment in property, or the actual cost of
construction through the entire history of the property, cannot be
sustained by any process of argument as a proper method of valuation,
nor can the method of computing the cost of construction of an adequate
modern property assumed to replace the existing property. The scope of a
valuation must be limited to the property as it exists on the date of
the appraisal, and it would be equally fallacious to include
non-existent and long-perished facilities, or to assume a hypothetical
and never-existing property.
There are many intricate problems in connection with a valuation for
rate-making or taxation which really belong to these undertakings, not
to valuation. They are usually brought into the discussion of valuation,
but have been here excluded. Among these are the separation of
interstate from intra-state business, and others, of great interest, it
is true, but foreign to the subject of valuation.
The question of the fair return on money invested is not referred to,
for the reason that it has no direct bearing on valuation, and for the
further reason that it has been quite exhaustively discussed in the
papers listed in the Appendix. The writer desires to make clear the fact
that he is not advocating low rates _per se_. The rate must be
determined to meet the special requirements of each investigation. The
Supreme Court of Maine says (97 Maine):
"The reasonableness of the rate may for a time be affected by the
degree of hazard to which the original enterprise was naturally
subjected. That is such hazard only as may have been justly
contemplated by those who made the original investment, and not
unforeseen and emergent risks, and such allowances may be made as is
demanded by ample and fair public policy."
While the Supreme Court of the United States, in Willcox _vs._
Consolidated Gas (212 U. S., 12), fixed a rate of 5½% as reasonable in
that instance, they said:
"No particular rate of compensation must in all cases be regarded as
sufficient for capital invested in business enterprises. Such
compensation must depend greatly on circumstances and locality.
Among other things the amount of risk in the business is an
important factor, as well as the locality where the business is
conducted and the rate expected and usually realized there upon
investments of a somewhat similar nature with regard to the risk
attending them. There may be other matters which in some cases might
also be properly taken into account in determining the rate which an
investor might properly expect or hope to receive and which he would
be entitled to without legislative interference. The less risk, the
less right to any unusual return upon the investments."
In view of these dicta, it is needless to argue whether a rate of 6% or
10%, or 15%, or more, be reasonable.
The writer has herein endeavored to narrate the story of the Michigan
appraisal in some detail, to review briefly subsequent similar work, to
present the main points in the legal decisions bearing on appraisal
practice, and to present his own views as to proper and legitimate
methods of valuation in the light of judicial opinions. He has attempted
to do this in the spirit of absolute fairness, without permitting either
early years of training in corporation service, or more recent
investigations for State and city, to bias the presentation of truths.
The subject is one which has not attracted the average citizen
sufficiently to compel him to give it deep study. Those who are familiar
with it all too frequently have views biased by interest, and it is
hardly conceivable that any final conclusion will be reached until each
and all of the main issues are determined by the Courts. When thus
determined, it will be done with wisdom and with justice. It is
impossible to study the cases referred to without being impressed with
the absolute fairness of this great tribunal. Quotations from decisions
have been included at considerable length in order to obviate the
criticism that the references do not convey the exact meaning of the
Courts.
The writer acknowledges the valuable suggestions, criticisms, and
information furnished him by Professors Henry C. Adams, Mortimer E.
Cooley and W. D. Pence; Mr. Henry L. Gray, Engineer of the Railroad
Commission, Washington; Mr. D. F. Jurgensen, Engineer, Railroad and
Warehouse Commission, Minnesota; Mr. Bion J. Arnold, and others who have
made possible the presentation of data regarding State and other
appraisals.
_Bibliography._—Accompanying this paper will be found a bibliography of
the principal articles on the subject of property valuation.
APPENDIX
BIBLIOGRAPHY.
_Railroad Valuation._—
"The Appraisal of
Plants for Public Services." Nicholas S.
Hill, Jr. _The Engineering Record_, June
8th, 1901. A review of the principles on
which a property is valued when purchased by
private parties or by municipalities.
"The Value of
Railways and Their Capitalization." H. T.
Newcomb. _Railroad Gazette_, August 29th,
1902. Abstract from _Yale Review_, August,
1902.
"The Census Office
Railroad Valuation." (Editorial.) _Railroad
Gazette_, September 1st, 1905. A discussion
of the work of Professor Henry C. Adams,
Statistician of the Interstate Commerce
Commission, and his assistants.
"Railroad Taxes and
Plans for Ascertaining the Fair Valuation of
Railroad Property." _The Railway Age_,
September 8th, 1905. Report presented at the
meeting of the National Association of
Railroad Commissioners, at Deadwood, S. Dak.
"Railroad Valuations
in State Reports." Professor Harold M.
Bowman. _Railroad Gazette_, September 8th,
1905. Abstract of a report, which explains
briefly the systems of valuation provided
for by the laws of the several States, with
a critical review of the systems and
administrative reports.
"The Determination of
Physical Values." Clinton S. Burns, M. Am.
Soc. C. E. _The Engineering Record_,
September 16th, 1905. Presents a
mathematical formula for fixing depreciation
on articles, based on age, with quite a
complete demonstration of the theory
presented.
"Valuation of
Railroad Property," Henry Fink. (Serial.)
_Railway Age Gazette_, July 24th, 1908, _et
seq._ A brief review of several methods.
"The Valuation of
Railways." (Serial.) _Railway Age Gazette_,
January 22d, 1909, _et seq._ A thorough
discussion of the subject, and one of the
best presentations of it from a rational
corporation standpoint.
"Some Neglected
Factors of Fair Valuation." (Editorial.)
_Railway Age Gazette_, March 5th, 1909.
"Railway Capital and
Values." W. H. Williams. (Serial.) _Railway
Age Gazette_, April 2d, 1909, _et seq._ An
address setting forth at length the views of
the railway managers who oppose valuation of
property for any purpose.
"Valuation of Street
Railway Properties." _Electric Railway
Journal_, June 19th, 1909. A general
discussion of the subject.