already exists, but we must not overlook the fact that we of to-day are
establishing the precedents for appraisals in the future. The whole
matter of valuations for rate-making purposes is still in a nebulous
form, as far as the public, and indeed, as far as the Courts, are
concerned. In the end it will devolve upon engineers to establish
logical methods of appraisal. To do so, they must be able to look on the
problem both as engineers and as jurists. Up to the present, however,
this broadness of vision has not characterized most engineering
appraisers, nor is it to be wondered at when the Courts themselves are
in a maze.
A great deal has been heard lately about "going concern value."
Ultimately, the Courts will hold that, as far as rate-making is
concerned, there is no such thing as "going concern value" in the
present meaning of the term. "Going concern value," in the final
analysis, consists of two elements: First, development expense (as
previously defined), and, second, capitalized surplus earnings. Surplus
earnings are ascertained by deducting from net earnings both taxes and a
low rate of interest on the investment, equivalent to interest on bonds.
Many factors may affect surplus earnings; but, that "going concern
value" consists largely of capitalized surplus earnings, cannot be
denied. What are surplus earnings? The public replies that they are
mainly the result of extortionate charges. This is doubtless correct in
many cases; hence, any investigation of costs which has for its object
rate-making must inevitably lead to repudiation of that part of "going
concern value" which is based on surplus earnings, if the surplus is at
all large. In a word, we reason in a circle if we capitalize surplus
earnings, calling the result "going concern value," and then undertake
to use "going concern value" as one of the factors in judging the
fairness of rates. To express the problem mathematically, we cannot
solve for a variable when the variable is allowed to exist on both sides
of the equation. Yet that is precisely what some rate-making bodies are
trying to do, and it is precisely what the Courts have often attempted
to do.
To escape this confusion there is but one possible step, and that is to
eliminate "going concern value" entirely. We must first determine the
element of cost, which the writer terms development expense, and we must
regard this item as a part of the cost of reproduction. We must next
cease to consider small rates of interest as being a "fair return" on
this cost of reproduction. When first-class mortgages draw 5%, it is
folly to talk of 6% as being a "fair return" on capital invested in a
business enterprise, especially when this 6% is figured on the actual
cost of reproduction of the property. It may be that 7% is an ample
"fair return" in some cases, but in others 10% will be found none too
much, considering the small size of the business and the risks involved.
The writer will not at this time discuss methods of determining how a
"fair return" should be estimated, but, in general, the process should
be as follows: From the gross earnings deduct the operating expenses and
taxes to obtain the net earnings. From the net earnings deduct a small
rate of interest (equivalent to interest on bonds) on the cost of
reproduction. The remainder is profit, and should be expressed as a
percentage of the gross earnings. This percentage of profit can then be
compared with similar percentages made by merchants, manufacturers,
farmers, and other capitalists, and then it can be determined logically
by comparison whether or not the profit made by a public service
corporation is "fair." We must adopt this method of attacking the
problem or we shall inevitably drive capital away from railway and other
fields of public enterprise.
The writer estimates roughly that a profit of 10% on gross earnings, as
above deduced, is about the same as a direct return of 7% on the cost of
reproducing the average steam railway.
In a recent appraisal of a street-railway system, the writer determined
the actual development expense of the property, deducing it from the
accounting records. It was an astonishingly high sum, even assuming only
7% on the cost of reproduction as being a "fair return." During his
appraisal of all the railways in the State of Washington, for the
Railroad Commission, the writer made a similar study of development
expense, but this was not included in his estimate of the cost of
reproduction, as it was then regarded as being a part of the "going
concern value" and he was not commissioned to ascertain the "going
concern value" of the railways. Not a single railway, as far as he
knows, has ever presented to a State Railway Commission, or to the
Interstate Commerce Commission, an estimate of its development expense
along the lines indicated. Instead, the railway companies have talked in
general terms of long construction periods—often claiming 20 years or
more—and of great expense incurred in building up the business, and of
franchise value, and of a score or more of non-provable costs. The
consequence is that they have frequently lost entirely the one great
item that they are clearly entitled to, namely development expense,
which is an item which can be absolutely proved from their accounting
records, and, therefore, rests not on the "hot air" testimony of
experts, but on facts that are incontrovertible. In like manner, other
public service corporations have often signally failed to prove the full
worth of their properties, because their claims for "going concern
value" have been ignored entirely. When a franchise expires, the "going
concern value" is usually looked on by the public as worthless, nor is
this view to be wondered at.
Mr. Riggs proposes adding to the physical value a minus "going concern
value," and he is logical in doing so, if it is conceded that values for
rate-making rest on profits; but this the writer does not concede for an
instant. Values for rate-making cannot rest on the very thing that it is
aimed to regulate, to wit, the rates charged. Until engineers and public
service commissions and Courts free themselves from this confusion of
cause and effect, there can be no rational theory of rate-making.
Values for rate-making must rest primarily either on the actual costs of
the production of a property or on estimated costs of reproduction,
including therein both interest charges during construction and the
sequel thereto—development expense.
Of almost as great moment as the item of development expense is the
question of depreciation. The author, in common with most engineers,
holds that depreciation should be deducted. This is a consequence of
regarding a public service plant as if it were a machine bought in a
second-hand store. A public service plant is a device which is intended
to perform a given service forever. It is true that its parts are
subject to wear, and must be renewed from time to time; but the plant as
a whole is everlasting, or practically so. Managers of public service
corporations, perceiving this fundamental truth, have rarely established
sinking funds for the redemption of any considerable part of the plant.
In a great railway system the renewal of a freight car is not a
proportionately larger item of expense than is the renewal of a tooth in
a steam shovel bucket owned by a contractor. This fact, coupled with the
permanence of the railway plant as a whole, has led railway owners to
make no provision for a return of the money lost in depreciation.
Railway ties in a large railway system inevitably reach a condition such
that their average age is exactly half the life of the average tie.
Shall a sinking fund be provided for ties? If not, where does logic
place a line of demarcation? When does an element of the railway plant
attain a condition of sufficient importance to warrant "writing off"
some of its value from the capital account? The facts are that railway
managers have not "written off" anything worthy of mention for
depreciation, and, in the writer's opinion, they have been perfectly
logical. Consequently, the operating expenses have been much less than
they would have been during the early years, had a sum been placed
annually in a sinking fund. Therefore, the development expense, as
deduced from the accounting records, is less than it would be if a
sinking fund were provided; and the amount of this difference is
precisely the amount of the depreciation. In other words, if
depreciation is to be deducted from the cost of reproduction, it must be
added to the development expense ascertained from the accounting
records; so that, in the final analysis, depreciation should be ignored
entirely in any appraisal of a public service corporation where the
object is either rate-making or purchase of the corporation by the
public. One qualification to this statement is needed, however, and that
is that the depreciation shall not have gone far enough to result in an
average age of plant less than half the life of the plant—that being the
ultimate normal operating condition.
Engineers have a duty to perform, in making an appraisal of the sort
under consideration, which is judicial in its character and should not
savor in the least of the pawnshop. The engineer engaged by a public
service commission should not for an instant make it his object to "beat
down the price," no matter by what far-fetched theory he may effect the
result. Nor are engineers inclined to do this, except when they regard
themselves merely as agents of the public by whom they are employed.
Unfortunately, many appraisers have as yet failed to realize that there
is a vital distinction between the dealings that should exist in public
affairs and those that actually exist in private matters involving the
purchase and sale of property. In the latter case, the buyer usually
takes every possible advantage of the helplessness of the seller. Is the
seller ignorant? See that he remains so. Is the seller hard-pushed for
money? Grind down the price accordingly. Does the seller offer goods
which are a bit shop-worn? Dwell on that fact, to the exclusion of all
else. Such are the tradesman's arts, and such, the writer fears, have
been the arts of some appraisers of public service property.
The writer believes that, under one form of agreement or another, nearly
every kind of public service can be more economically and better
performed by a public service corporation than by the public itself
through employees directly hired. But if America is not to pass speedily
into Government ownership and operation of all public utilities, there
must be a pronounced change of attitude on the part of the public toward
capital now invested in public service corporations. Even as engineers,
we are apt to be unconsciously influenced in our attitude toward public
service corporations, not only because of the present public attitude,
but because we are often put to great inconvenience by the
ill-considered resistance of the corporations whose property we are
called on to appraise for the public. Our duty plainly consists, first,
in regarding a public service corporation as a public agent, and,
second, in allotting such values that this public agent will receive a
full and fair return for every dollar judiciously and honestly spent in
building and developing its property. In carrying out this plan, the
writer finds it wise to study the entire financial history of a
corporation, going carefully through both the construction accounts and
the operating accounts from the beginning.
The desirability of analyzing the actual costs of construction,
betterment, and operation of public service corporations, preparatory to
estimating the cost of reproduction, cannot be too strongly urged upon
appraisers. Unfortunately, many corporations refuse access to their
records, or claim that the records are too incomplete to be of value.
However, when they realize that from those very records can be deduced
one of the largest items of cost of reproduction, namely, the item of
development expense, they are certain to show as much willingness as
they now show aversion to disclosing their records.
The writer has recently completed an appraisal of a street railway
system, the managers of which placed at his disposal the entire
accounting and engineering records. From these the development expense
was deduced, and forms an item which can be demonstrated in Court, if
need be, instead of being the subject of unsupported "expert testimony."
As far as the writer knows, this is the first time that a street railway
corporation has voluntarily opened all its books for use in an appraisal
which may be made public. May it not be one of the harbingers of a
far-sighted action on the part of public service corporations, which
will result eventually in eliminating entirely the hostile attitude of
the public toward its accredited agents?
Reverting again, and finally, to the question of development expense, it
will be seen, after study, that the method of deducing it from the
accounting records provides for every possible item. The cost of
advertising, the cost of colonization, and canvassing by agents engaged
in building up the business tributary to the corporation, the cost of
developing an efficient business organization and an efficient
plant—every possible item of developing the business finds accurate
record in the development expense deduced from the accounting records as
outlined. This may not be apparent at first glance, but a little
consideration proves it to be so. If, for example, $20,000 has been
spent annually for ten years in advertising to secure business, the
operating expenses have been increased exactly $20,000 for each of the
ten years. Consequently, the annual deficit below a "fair return" on the
investment has been made $20,000 greater each year than it would have
been had no expense for advertising been incurred. In other words, the
deficit below a "fair return," which is the development expense, shows
automatically the amount spent for every such item as advertising. The
writer regards this automatic register of development expenses as being
one of the most important features of his method for determining such
expense. It removes the entire problem from the realm of guess-work and
expert testimony, and makes it a problem in engineering economics. It
involves no question as to whether or not the existing rates charged for
freight, or for any other service, are fair.
ARTHUR L. ADAMS, M. AM. SOC. C. E. (by letter).—This paper, in spirit,
diction, and contents, is a masterly presentation of the best thought
and argument, by engineer specialists and the higher Courts, concerning
this difficult subject—a presentation which only one intimately
associated with the question for years, as has been the author, could
hope to make. It is of special interest, too, because it deals
fundamentally with the Michigan railroad valuation, now ten years old,
and deservedly considered somewhat ancient in the evolution of what may
be termed the logic of valuation methods. The frank acknowledgment of
the now apparent deficiencies or errors of that work, notably in the
defective method and resulting under-valuation of real estate, as well
as the upholding of that which still appears to the author to be sound
in principle, are excellent manifestations of the constructive and
judicial spirit so necessary to the making of any substantial
contribution to the art.
Unanimity of opinion in matters of detail, even among those specializing
in this line of practice, cannot be expected, especially in a general
discussion. Details must receive their emphasis from local coloring and
local conditions. Making allowance for these local conditions in
Michigan and other contiguous States—notably conditions of population
and flat topography—and remembering that the basis of the paper is a
railroad valuation for purposes of taxation, and not a water-works
appraisal for annual rate-fixing in a semi-arid region of rapid
development, or some other widely differing utility, it seems to the
writer that the author has been singularly fortunate in giving
expression to views with which specialists will for the most part agree.
The limitations of the logical application of the methods suggested,
however, are not sufficiently defined. Early in the paper an effort is
made to avoid the necessity for this, and to simplify the treatment by
limiting the scope of the paper, in the following language:
"This paper is confined to a discussion of the methods which should
be used in arriving at a correct figure of cost of reproduction and
depreciation—it does not take up questions involving the propriety
of those figures when reached. The propriety or legality of using
such figures as a basis for an assessed valuation, as a basis for
rate-making, ... will be conceded no place in this paper."
Such a restriction, however, seems to the writer to leave the subject
much confused. It is impossible to judge of the propriety or soundness
of a method of valuation while ignoring its purpose and failing to point
out the limitations of its logical application. To confine discussion to
a consideration only of cost of duplication and depreciation of physical
properties is presumably an attempt to avoid the difficulties incident
to the application of such results to specific purposes, and is in line
with the frequent argument of some attorneys in litigated valuations,
that the engineer must not encroach on the province of the Court by
having, much less expressing, any idea relative to the application of
his figures to the final solution.
With this doctrine the writer has no sympathy. The engineer is
essentially an economist, and no one is more fully qualified to aid,
either directly or as an adviser to the Court, in the final
determination of value for specific purposes, provided he is trained in
the construction, operation, and valuation of such properties as are
under consideration. To accept any less responsibility than this is to
become party to inferior measures leading to popular misconception, and
is justified only as a practicable first step toward the final
realization and acceptance of the larger duty.
All suggested methods of valuation should be subjected to close logical
analysis, with a view to their purpose. The unsuitability of the method
used in the Michigan appraisal to many classes of appraisals is
apparent, and can be readily indicated. Much space is given to
justifying the appraisal of all so-called non-physical elements by the
capitalization of the residue of net earnings after allowing interest on
the investment in the physical properties. This the author refers to as
Professor Adams' method. The addition of the physical to the
non-physical values, as thus determined, is supposed to give the value
of the property as a whole. It is evident that it gives, by indirection,
the same total valuation as would be obtained by the direct
capitalization of net earnings without any determination of physical
values, _per se_, and, as a method, is therefore not what it purports to
be. Since value, by this method, is in reality dependent on earnings, it
follows that where rates are fixed by governmental authority, with the
property value as the base, as is done annually in California in cases
of privately owned water and lighting plants, the method suggested is
without logical application, and the property values of such
corporations must be determined and justified on other or modified
grounds. Hence the necessity for dealing with such elements as so-called
"going concern," franchise, and other possible assets, each
independently, as is usually done in water-works appraisals, instead of
collectively, as in the Michigan appraisal.
It should be made clear, therefore, that the method used in this
railroad appraisal, for the determination of non-physical values, simply
reduces the whole to one of capitalization of net earnings, and
presupposes no governmental regulation of rates with the value of the
property as the base; and, unmodified, has a comparatively narrow range
of application.
The author seems to see difficulty ahead in dealing with rate-making by
this method, for he says, near the close of his paper: "There are many
intricate problems in connection with a valuation for rate-making or
taxation which really belong to these undertakings, not to valuation,"
but, in stating some of these difficulties, he does not point out the
impropriety of determining value by capitalizing that (earnings) which
it may be the object of the valuation to determine and fix.
Regulation of rates by governmental authority, which means their
limitation to that which is reasonable and just, will probably in the
future be the purpose in the making of most valuations of the property
of public service corporations, and no methods or rules for the making
of appraisals can be considered as being at all complete or fairly
comprehensive which do not meet the logic of such an end.
If capitalization of net earnings is to determine railroad values for
rate-fixing, whatever the process, it must presuppose a fair and
equitable rate, thus following the rate, instead of the rate following
the property value. This is but a shifting of the difficulty; for, what
constitutes a fair and just rate, irrespective of the value of the
property used, is at least as difficult of determination as is the
property value, irrespective of its earnings. Valuations, to be useful,
must have their purposes carefully predetermined, that the right
application of principles may be made.
Perhaps nowhere more than in California has thought been directed along
this line, for the organic law of the State for thirty years has
required the annual fixing of rates for water and light companies by
public official bodies, and many important cases involving rates and
valuations of large properties, chiefly in later years, have been tried.
Unfortunately, the most important and best tried of these have not yet
reached the United States Supreme Court. The result, thus far, is too
long a story to be told now, but it may be said that capitalization of
earnings in any form is not regarded as a logical basis of value under
such conditions. Franchises, as they exist here, are not regarded as
having value, unless from unusual circumstances. "Going concern" value
is recognized, but its money measure is sought through other channels
than present net earnings.
The author's emphasis on the necessity for eliminating the personal
equation, as far as possible, is commendable, but a large exercise of
discretionary judgment is inseparable from the process of appraisal. The
fullest investigation of all pertinent facts should be made. Too much
must not be expected from rules and formulas. They are education only.
Governing principles must be understood, and subsequent procedure the
writer cannot better express than in the words substantially as used on
a former occasion:[47] Having considered the various factors likely to
influence the value of any property under consideration, and having
summarized the results, it will remain to determine the varying degrees
of importance and weight to attach to each, and to decide, in view of
all the attendant circumstances, what the amount is on which the company
is entitled to receive a suitable return. This final solution can never
be reduced to a mathematical formula applicable to all cases. The
inquiry will have established approximate limitations, both as to
maximum and minimum, but there will then usually be found remaining
quite a wide intervening field for the exercise of discretionary
judgment.
That the final result will depend to some extent on the personal
equation, does not of necessity detract from its worth. It only shows
the greatness of the problem, which requires for its solution the
exercise of faculties higher than the application of mere formulas and
mere routine, faculties which are rooted in laborious thought, in ripe
experience, in moral worth.