Part 1

AMERICAN SOCIETY OF CIVIL ENGINEERS INSTITUTED 1852

TRANSACTIONS

Paper No. 1190 THE VALUATION OF PUBLIC SERVICE CORPORATION PROPERTY.[1]

BY HENRY EARLE RIGGS, M. AM. SOC. C. E.

WITH DISCUSSION BY MESSRS. F. LAVIS, CHARLES H. HIGGINS, S. D. NEWTON, WILLIAM V. POLLEYS, C. P. HOWARD, J. E. WILLOUGHBY, HENRY C. ADAMS, CARL C. WITT, R. A. THOMPSON, CHARLES H. LEDLIE, WILLIAM G. RAYMOND, W. H. WILLIAMS, P. E. GREEN, E. KUICHLING, RICHARD T. DANA, GEORGE T. HAMMOND, LEONARD METCALF, CHARLES HANSEL, J. MARTIN SCHREIBER, CLINTON S. BURNS, HALBERT P. GILLETTE, ARTHUR L. ADAMS, C. D. PURDON, A. MORDECAI, W. B. RUGGLES, AND HENRY EARLE RIGGS.

INTRODUCTORY.

The industrial and economic development of the past two decades has opened many new lines of special work in the Profession of Engineering, none of which is more difficult and complicated or of greater ultimate value to the public at large than that of the appraisal or valuation of the property owned and operated by public service corporations; and none of the fields of engineering specialization requires greater care or calls for more skill, experience, integrity, or sound judgment.

The individual engineer, or commission of engineers, entering upon an appraisal of large magnitude, particularly one including properties of more than one company, will find conditions varying in every one, and each property presenting new, complex, and confusing elements of value to pass upon and determine.

Prior to 1900 there had been few calls on engineers for large appraisals, and the literature descriptive of engineering effort along this line was practically nothing. Since 1900 many extensive appraisals have been undertaken by States, by railroad and banking corporations, and by cities; certain well-defined lines of practice have been developed; many differing opinions as to certain methods and principles have been brought out; and enough has been added to the printed literature to enable one to compare methods of work and to fix with reasonable certainty upon some as correct, and to discard others as improper.

There are so many complex factors entering into the problem of valuation, so many widely different plans have been presented, and there are so many thinking men who have opposed and do honestly and sincerely oppose any form of valuation, that a most thorough study of the subject should be made. It should be examined from all angles, and every possibility of danger from legislation regarding it should be weighed with utmost care.

The question of railroad valuation, involving as it does the largest industry of the nation, naturally takes first place in such a discussion, but so many of the general principles of railroad valuation are applicable to the appraisement of corporate property, so many arguments have been advanced by engineers and others, and so many judgments of the Courts have been rendered in connection with water-works and gas-works valuations, that it is not desirable to limit this discussion wholly to the problem of railroad valuations.

The reasons for requiring that valuations be made may be broadly divided into two general classes:

_First.—As a Matter of Public Interest._—The public, and particularly the investing public, requires valuations in order to guard against unworthy and dishonest corporation securities, to be assured that corporations are bearing their legitimate and proper share of the burden of taxation, and to furnish a proper basis for fixing equitable and just rates for the services rendered by the corporation.

Under this class would come all appraisals made for information to be used as a basis for legislation relative to:

(_a_) _Taxation of Corporations._—Such were the valuations in Michigan and Wisconsin.

(_b_) _Rate Regulation._—This was the reason which prompted the work in Minnesota and Nebraska.

(_c_) _Limitation of Capitalization._—The regulation of issue of stocks and bonds was the purpose of the Texas valuation.

(_d_) _Fixing a Price for Sale._—Many of the water-works and electric light valuations were made in order to determine a fair price to be paid for the property at the expiration of the franchise.

(_e_) _The General Information of the Public._—To be used in connection with the fixing of terms for franchise renewals, etc., etc.

_Second.—As a Matter of Corporation Necessity or Expediency._—Valuations are made in order to guide large investors, to secure a safe and up-to-date basis on which to negotiate a sale, a purchase, or a reorganization of the property, or a consolidation with other like properties, and to secure justice to honestly administered corporations.

The great majority of appraisals under this head have been in accordance with some other methods than those adopted in the State valuations. It is not intended in this paper to engage in any argument as to the various purposes of appraisals, or even to urge the necessity or desirability of a general appraisal of properties. An absolutely accurate and correct statement of the cost of reproduction of all the physical properties of the railroads of the country, a correct statement of the actual capital needed to reproduce these properties as they exist, and, along with this, a statement of the actual physical depreciation, would be a document of vital interest.

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 (rate-making being an art in itself involving complications as great as those encountered in valuation), or any arguments as to the justice or injustice of legislation restricting issues of stocks or bonds, will be conceded no place in this paper. It is assumed that all these questions would have been taken up and a satisfactory answer reached before a valuation could have been ordered.

The different elements of value in property, the relations of this property to the public, the method of determining the worth of these elements of value which have been adopted in the past by men engaged on valuation work, a comparison of these methods, a discussion of the objections that have been made to them, and a presentation, not only of the writer's views as to proper methods, but those in which he disagrees with usages adopted by others—these define the scope of this paper.

No matter what particular end is to be served by a valuation, the commission engaged upon it will be asked to furnish a fair value, perhaps with reasonable limitations in the instructions, perhaps with a general and indefinite instruction to find the value. They will encounter, among other difficulties:

_First._—The fact that human machines are not exact duplicates, and that allowance must be made for a large measure of error, on account of the personal equation of the men engaged on the work, as individual errors of judgment are frequent on any work of magnitude. This personal element must be corrected by uniformity of method, by constant checking, and, as far as possible, by subordination of personality to system.

_Second._—The fact that human selfishness is a dominant quality—the railroad manager who opposes methods which he believes will increase values in an appraisal for taxation, or who, on the other hand, uses every possible argument to increase values if the work be as a basis for rate-making or for restriction of bond issues, or the State official who is desirous of using original cost on a valuation to be used for rate-making in order to keep the valuation down to a minimum, and the politician who depends on an unenlightened public opinion to create sufficient outcry to influence the work to his advantage—are all actuated by a perfectly human wish to attain ends which seem to them desirable, and are but typical of men who will endeavor to influence every appraisal.

In view of these considerations, it is a question whether results are not frequently affected by the knowledge of their intended use, and whether a system which will entirely remove such causes of error can be applied to the work.

If an engineer, or a commission of engineers, is directed to examine a certain property and report the true cost of reproduction, depreciation, or present value, taking into account all facts connected therewith, the final figures should not differ, whether the report is to be used as a basis for reorganization, sale to another corporation, or is to be used by a State legislature as a basis for formulating a rate bill, or as a basis for a value for taxation. The result secured is a necessary preliminary on which depends the accuracy, fairness, and justice of the other work which is to follow. This is an engineering work, a statement of certain physical property, the estimated cost of reproducing it new, less the estimated depreciation, and, beyond the differences due to personal judgment, these figures may not vary.

The word "value" is in common use, and yet, in the minds of many people, its exact meaning is vague. It is true that the "value" of a property is an unstable figure, subject to fluctuations due to natural or artificial causes, and that a material change in value may occur suddenly, but the "value" of any given property on any given date is, or should be, from an engineering standpoint, a definite sum which may not be varied or changed to suit the whim or will of the people for whom the work is done.

In all the subsequent discussion of values and methods of obtaining values, it is assumed that, unless specifically limited to a determination of cost of reproduction and depreciation, a valuation commission should be governed by the following rules:

_1._—No account may be taken of the purpose for which the resultant figure of value is to be used; and the result should not vary, no matter what that purpose may be.

_2._—The resultant figure should be the honest judgment of the men composing the commission, as to the actual cost of reproduction, present physical value, or "fair value," and should be ascertained by a systematic and scientific method which takes into account all the facts concerning the property, its physical value, its strategic location, its operating revenues and expenses, and its franchises, rights, competition, opposition, and all other tangible or intangible elements which would affect values. The method of valuation should be such as to minimize or entirely eliminate all differences due to errors of personal judgment.

_3._—All properties being appraised are considered as operating properties. One which is dead, inert, and not in use, cannot be considered as coming under such a discussion as this, and such properties are not treated in this paper. The term "going concern" is not used in connection with the physical property, any element of value implied by the term, over and above the "overhead charges," being treated as an intangible or non-physical element of value.

In stating this position, the writer is aware that it is a difficult matter indeed to get away from the fact that some specific purpose—taxation, for example—is the definite end in view in every valuation, and that, instinctively, men engaged on the appraisal will find themselves modifying their figures to meet some real or fancied condition which they conceive might arise, or to prevent some injustice which they believe might be done. Every subordinate employee needs to be watched, every man in charge must watch himself, or he will find himself unwittingly, almost instinctively, coloring his results by some old prejudice of his early years of employment, or some loyalty to his own ideas of governmental or economic policy. The writer has noted this in every appraisal on which he has been engaged, and calls particular attention to it as the first difficulty which must be overcome in the organization of the force for a large appraisal.

In the following pages all complications which might arise from the purpose of the appraisement are considered as eliminated, and the possibility of erroneous conclusions being reached by reason of the personal factor (while recognized as being ever present) will not be specially emphasized.

Footnote 1:

Presented at the meeting of January 4th, 1911.

THE RELATION OF PUBLIC SERVICE, OR QUASI-PUBLIC CORPORATIONS, TO THE PEOPLE.

In reference to questions of value, the engineering commission must hear, consider, and reconcile arguments advanced by adverse and often hostile interests. On the one side stand the corporations, with large financial interests involved, often with an excessive amount of stock and bonds issued on the property, the existence of which issues the corporation wishes to justify, and, whether properly capitalized or not, the management being imbued with the perfectly human desire to defend corporate interests from attack of any kind; on the other side is public opinion, often unreasonable, often misinformed, and frequently prejudiced.

It appears necessary, therefore, to consider briefly the relation which these interests bear to one another, to study the causes which have led to mutual misunderstandings, and to note the proper relations which should, if possible, be established and maintained between the people and those corporations organized to perform certain of the functions of the State.

A public service or quasi-public corporation is a corporation which is operating under the terms of rights, grants, or franchises given by the public, either to this particular corporation direct or granted by statute to a class of corporations.

The property of the corporation is used to render certain services to the public, with the expectation of financial gain.

It is not material whether the grant be a franchise permitting a water-works company to use the streets and alleys of a city for its mains, and the service be the pumping of water for domestic service and fire protection, or whether the grant be the statutory rights of corporate existence and eminent domain, and the service rendered be the transportation of freight and passengers; the general principle is the same; the company has secured from the people certain rights which enable it to do business, and the people are directly benefited by the services rendered by the company. The increased comfort of living makes for the growth of the city; the increased transportation facilities build and develop the country traversed by the railroad; and this growth and development, not only operate to the advantage of the people, but also to that of the company in the way of increased business and increased revenues.

The capital required to build and develop these properties was furnished in the hope of, and with the expectation of, a proper financial reward. It has frequently happened that such properties have been built years in advance of sufficient development to support the enterprise, built, in fact, without expectation of immediate returns, and long periods of time have often elapsed before any profit has been secured.

It has also frequently happened that corporations have been aided to a very large extent by public funds, by the voting of aid bonds, by the donation of large tracts of land, by payment for certain service at such rates as would largely relieve the company from loss in operation, by the remission of taxes, or by the direct donation of funds.

The company is clearly entitled to earn a reasonable profit on the actual capital invested, in addition to the legitimate cost of operation, payment of taxes, and sinking funds to cover depreciation and obsolescence.

The public is clearly entitled to good service at the lowest rates that will permit the company to earn its reasonable profit and expenses. Increases in tonnage, population, and consequent net earnings of the corporation should entitle the public to a benefit in reduced charges for service, when the increased earning is of a permanent character.

The general tendency of the Courts has been to treat a franchise as a contract, and to be governed closely by the language and evident intent of the makers, but to safeguard the rights of the public to the fullest extent consistent with justice.

A franchise requires specific performance of specific acts. Nothing will be assumed or implied. The Courts recognize that the investors are entitled to reasonable returns, and that the public is entitled to fair rates.

In the case of Los Angeles Water Company _vs._ City of Los Angeles (103 U. S., 711), the United States Courts held that at the expiration of a 30-year franchise, which provided that the city was to pay for the value of all improvements, when the city failed to agree upon, tender, or pay such value, so long as the company complied with the terms of the contract, and until the city terminated it by making or tendering payment, the passage of an ordinance by the city fixing rates was void.

In the case of Weatherly _vs._ Capital City Water Company (Ala. 22 So., 140), the Alabama Courts held that the acceptance of a franchise involved a grave responsibility, and that the company could not stop furnishing water and fire protection, even if the work was done at a loss.

In the case of Myer _vs._ Brown (65 Cal., 589), the Court said:

"It is well occasionally to recall the fact that there is no more reason to permit a municipal government to repudiate its obligations entered into for value, than to permit an individual to do so. Good faith and fair dealing should be exacted of one equally with the other."

Judge Brewer, in the Kansas City Water-Works case (62 Fed. Rep., 853), said:

"All contracts involving property rights and obligations, between municipalities and individuals, must be presumed to be based upon and to recognize the ordinary laws of business transactions."

In 1903 the Maine Supreme Court issued a set of instructions to appraisers appointed to fix values of certain properties. The Court set forth its views as follows:

"Summarized, these elemental principles are, the right of the company to derive a fair income based upon the fair value of the property at the time it is being used for the public, taking into account the cost of maintenance and depreciation and the current operating expenses, and the right of the public to demand that the rates shall be no higher than the services are worth to them, not in the aggregate, but as individuals."

The Supreme Court of the United States has again and again given its views, which may be summarized as follows:

"It cannot be said that a corporation is entitled, as of right, without reference to the interests of the public, to realize a given per cent. upon its capital stock. When a question arises whether the legislature has exceeded its constitutional powers in prescribing rates to be charged by a corporation controlling a public highway, stockholders are not the only persons whose rights and interests are to be considered. The rights of the public are not to be ignored.

* * * * *

"The public cannot properly be subjected to unreasonable rates in order simply that stockholders may earn dividends. The legislature has the authority in every case, where its power has not been restrained by contract, to proceed upon the ground that the public may not rightfully be required to submit to unreasonable exactions for the use of a public highway established and maintained under legislative authority." (164 U. S., 578.)

"It is not to be inferred that the power of limitation or regulation is itself without limit. This power to regulate is not a power to destroy, and limitation is not the equivalent of confiscation. Under pretense of regulating fares and freights the State cannot require a railroad corporation to carry persons or property without reward, neither can it do that which in law amounts to the taking of private property for public use without just compensation. * * *" (116 U. S., 307.)

In the case of Smyth _vs._ Ames (169 U. S., 466), the Court said:

"If a railroad corporation has bonded its property for an amount that exceeds its fair value, or if its capitalization is largely fictitious, it may not impose upon the public the burden of such increased rates as may be required for the purpose of realizing profits upon such excessive valuation or fictitious capitalizations; and the apparent value of the property and franchises used by the corporations, as represented by its stocks, bonds and obligations, is not alone to be considered when determining the rates that may reasonably be charged. * * *

"We hold, however, that the basis of all calculations as to the reasonableness of rates to be charged by a corporation maintaining a highway under legislative sanction must be the fair value of the property being used by it for the convenience of the public.

* * * * *

"What the company is entitled to ask is a fair return upon the value of that which it employs for the public convenience. On the other hand, what the public is entitled to demand is that no more be exacted from it for the use of a public highway than the services rendered by it are reasonably worth."

The relations between the corporations and the public that they serve have been clearly defined by the Courts, as the foregoing quotations show.

That the mutual relations existing between the management of the corporations and the public are far from what they should be, there can be no doubt. On the one hand, the great mass of the voting public is uninformed as to actual revenues, disbursements, and operations of the corporations, as to whether their income is unreasonably large, or whether they are struggling to exist. The sums of money involved in the dealings of the corporations are so stupendous in comparison with the amounts used in an ordinary private business—even in one of considerable magnitude—that the majority of the public cannot comprehend them. The published statistics are in such form that only the careful student of affairs can understand or analyze them, and but few of the public officials who receive them are able to read the reports of the properties and comprehend them. As a consequence, the corporation, as a political issue, has been the subject of jest, gibe, and cartoon; there has not been an intelligent public discussion of available reports and statistics, and it may be said that, generally, the mass of the public has come to class all corporations as grasping, overbearing, and unjust, and to consider them all as exceedingly prosperous. This has been taken advantage of by politicians for their own selfish ends, and has led to sundry legislation, some of which has been unreasonable and unjust to the corporations, and much of which is aimed at real abuses that never ought to have existed.