Part 21

In the published articles treating on the subject of valuation, much stress is laid on the intangible or non-physical elements of value. They have been termed "going concern values," "business values," "good will values," "franchise values," as well as "non-physical" and "intangible" values.

So much of the argument of many writers has been taken up with this phase of the question that it is impracticable to recapitulate the various arguments in support of giving these elements a place in the appraisal.

The writer cannot agree with those who would place any of these elements of value in the physical appraisal.

Value is given to a property, either by reason of the fact that it is an instrument for earning profit, or that it does earn profit or gives promise of profit. The actual investment of capital in a new plant is made with the expectation of earnings. It is not reasonable to attach as physical value, to such a plant, any value in excess of the actual investment. Nor does it appear to be any more reasonable, in the case of an old plant, to assign arbitrary and fictitious values over and above the actual investment remaining in the plant, unless such values are justified and supported by actual earnings in excess of such a rate of interest on the money invested, as it would earn if invested in some non-hazardous security, and—carrying out the clearly-expressed idea of the Courts—such intangible value can only accrue when the rates charged for the service are fair and proper.

The capitalist seeking investment bases his ideas of value on:

(_a_) The market price of stocks and bonds, an estimate of worth based primarily on actual earnings of the property, but affected to some extent by outside conditions; or

(_b_) On the capitalized net income, or actual earnings, of the property; or,

(_c_) In the case of a new property, on an estimate of what the probable earning capacity of the property will be, where the business is more fully developed.

Methods (_a_) and (_b_) ignore cost of construction, or present investment in physical property, and base a value on past performances. Method (_c_) is based purely on hypothetical earnings, but the only real measure of value in this instance is the actual amount of capital that has been invested.

No appraiser would be justified in placing a "going concern" value, in excess of original cost, on a new property, nor would he be justified in placing such a value on a property 3 years old, or 10 years old, unless the net earnings were such as to indicate that the property had a business or commercial value in excess of the physical property value.

It would seem reasonable to say that this difference between the physical value and the value based on earnings represents the "good will," "established business," or "going value," and all the other non-physical elements of value.

To take a specific example: it would be impossible to separate the different elements of intangible value of the Michigan Central Railroad, and say that a certain sum of money represented "good will," another sum "established business," still another sum the "franchise value," and still another sum the "going concern."

The "going concern value" of the Michigan Central Railroad is exactly analogous to the going concern value of the hypothetical water-works cited by Mr. Alvord. Instead of having water pipes connected with buildings along the mains, and considerable sums invested in appliances for using the water, there are manufacturing plants located along the railroad, connected with it by side-tracks built by the industry, and depending on the transportation facilities of the road for their connections with their customers, the very life of the manufacturing plant dependent on its connection with the road. This is "connected good will" of the same kind as described by Mr. Alvord. Yet, to fix a value on it by the method described by him involves going into the realm of conjecture and speculation to a degree that could never be sustained.

Difficulties as great would be encountered in an effort to separate and set up any other elements which go to make up the intangible value, and any figure thus determined would be absolutely incapable of proof.

The Courts say that the value must be the "fair value of the property being used," all the conditions being taken into account (169 U. S., 466).

It can be readily seen that the physical present value is not always—indeed, is not often—the "fair value." The "fair value" may be more, or less, than the present value of the physical property. It would seem to be reasonable to interpret the Court's meaning of the term "fair value" to be the value as a business or commercial property, taking into account the actual investment existing in the property, together with any favorable conditions which would enable it to earn, on rates which were fair and reasonable to the consumer, an income in excess of a usual rate of interest on the actual investment, or any unfavorable ones which under the same rates would reduce its earnings to less than usual interest. If such an interpretation be allowable, it would appear to be correct practice to use a "fair value" made up of two elements: a physical value, representing the investment, and a non-physical value, representing all the elements which affect that investment to give it favorable or unfavorable financial returns. Is it not, then, proper to conclude that the non-physical or intangible value, composed of all these various elements of value, can only be determined absolutely by a study of the earnings and operating expenses? Is not this clearly what the Court had in mind in the Nebraska Rate Case?

Much of the argument on the subject of "going" values and other kindred elements of value consists of statements of theory and generalities, and may be said to be merely argument to support the theory that there is an intangible element of value. If work of valuation is to be of any real benefit, must it not give a definite result? Must not this result be based on absolute facts?

In securing the present value of any physical property the fixed and certain facts are:

The inventory of property owned.—This is absolute.

The cost of reproduction of the different elements.—This is capable of determination within very close limits.

The depreciation.—This is in a measure a matter of judgment, based on the experience, not only of the engineers making the appraisal, but of the entire scientific world; and, if properly made and properly checked, there should be no very wide divergencies in results.

The items of general expense.—These, based on available statistics, must be estimated. The exact determination of these items will be made comparatively easy as statistics based on the uniform classification of accounts become available.

It is believed that the physical values, when secured along the lines suggested, are definite enough to be accepted as a fair estimate of the amount of capital actually invested in the property, and that, if a sufficiently large force of men experienced in the construction, operation, and financial management of the kind of property under investigation is engaged on the work, the element of uncertainty due to errors of personal judgment can be largely eliminated.

The next question to be determined is whether there is, at the time of the appraisal, any non-physical value, and, if so, to select a method for computing it that will give a result that can be definitely supported as to the particular property under investigation. A study of the income accounts of the property being valued should be made. If the property is not earning a sufficient sum to pay its operating expenses, and taxes, and to set aside a fund to cover depreciation and obsolescence, there is clearly no intangible value of any sort to be added to the physical value. If, however, after all these charges are taken care of, there is a net earning which is large enough to pay 4 or 5% on the physical property and still leave a surplus, is it not perfectly reasonable and proper to hold that this surplus represents earnings on all intangible elements of value?

The contention that all the different elements of non-physical value merge into one intangible value, not capable of separation, will doubtless be objected to by many engineers and corporation managers.

Among the elements adding value to property have been described:

_1.—"Going Concern" Value._—Professor Mead defines this as the value due to the fact that a plant has consumers actually utilizing its product, and that it is in actual and successful operation and has its business developed. This value is the worth of the plant in excess of a similar plant without connections, and constitutes an asset in the consideration of its physical value. Mr. Alvord has used the term "connected good will" as applicable to this element of value.

The writer does not concede that "going concern" is a proper element to consider in the physical value, as it does not represent any part of the cost chargeable to capital, and the physical valuation should be confined to the determination of capital invested.

It has already been argued that to the physical property as inventoried should be added proper figures to cover organization, legal expense, administration, engineering, and contingencies. All these items are in the nature of additions on account of the fact that the property is a "going concern." It is maintained that these costs should carry to the present value column as values, for the reason that all these services rendered in connection with the creation of the property remain, unimpaired in value, as long as the property is operated. When, however, a property ceases to be operated, and is abandoned and dismantled, not only do all these elements absolutely disappear, but also all increments of value by reason of the special use of the property are wiped out, and there exist only a lot of partly worn out and partly obsolete machinery and equipment, salable at scrap values, buildings constructed for a purpose which renders them unfit for other use, and land partly salable at going prices and much that will not sell at all.

As long as a gas-works, a water-works, or a railroad is in operation and earning, it is a "going concern," and all increments which attach to its physical property as a whole continue to exist, even if the physical value of the property is greater than a fair value. That fair value can be determined and reached by means of a negative non-physical value.

In view of these things, it would seem to be highly improper to add to physical value anything more for "going concern." In the final report of U. S. Judge R. W. Tayler, Arbitrator in the Cleveland Street Railway matter, in December, 1909, the following language supports the above contention:

"I allow nothing for going value, except in so far as that is the result of the necessary expenditure of money in building the road, acquiring its land, power-houses, and equipment, and putting them into successful operation. The expenditures for these purposes are, and necessarily must be, included in the valuation of the physical property."

_2.—Developed Business._—It is perfectly clear that the "fair value" of a property must take into account the established business of the concern. This really is covered by the "going concern values," as defined by Messrs. Mead and Alvord. The only manner in which this can be determined intelligently is by an analysis of income accounts.

_3.—Cost of Handling Business._—A railroad with heavy grades, bad curves, poor equipment, or unskilful management is not nearly as valuable a property as one having good line and grades, and far-sighted, economical, and skilful management, and which handles its business at a lower cost per unit.

In such cases the differences in location and management are bound to show in the earnings, adding to the physical value of one property and possibly taking from the value as shown by the physical appraisal in the case of another.

_4.—Good Will and Established Organization._—These are valuable assets. It is difficult, indeed, to attach exact weight to these elements of value, except as they are shown in the intangible value indicated by the earnings. In most cases of public service companies, as is argued elsewhere, it is doubtful if such elements are entitled to any place in a public valuation.

_5.—Franchise Values._—These cover various specific items arising out of the ownership of special franchises, or, out of the general rights granted by law to corporations.

All these elements of value have been presented, and have been supported by able arguments. No one has offered a method of separating them. While there is universal recognition of their existence, in the case of many properties, they are supported by nothing visible or tangible. They are practically inseparable, one from another. They are not always present, and the application of any such arbitrary rule as that suggested by Mr. Alvord would make it possible to place values which were purely fictitious. Therefore, it follows that, if they are to be considered at all, they must be treated as parts of one intangible value, and that value must be derived from a study of the income account of the property.

There are other points to be noted as reasons why no such elements of value may attach to the physical property.

Any value of an old and well-established property in excess of a fair return on its physical property (in other words, any intangible value) must be limited and restricted, when used for rate-making purposes, by the value to the consumer of the services rendered. The Courts hold so squarely that the rates charged for services must not be more than the particular service is worth, and that the Company may exact a fair return on property actually being used, that it is not conceivable that any valuation which attempts to attach fictitious elements of value to physical property can be sustained.

This argument is not intended as an attempt to show that intangible values are improper and that where they exist rates should be lowered. It is contended that the determination of rates that will be just and fair to all competing companies involves other consideration than the valuation of either physical or intangible properties, and that when all these rate-making problems are properly solved, there will remain large intangible values on the well-designed plants. It is further contended that the work of valuation should separate the tangible and intangible elements, so that the further work of rate-making or assessment may not be complicated by improper elements which are included among the items of the physical properties.

In consideration of franchise value, the history of the corporation should be investigated with a view to determine what part the public played in the creation of the property.

The granting of aid bonds, of public lands, and of aid money to railroads, the giving of encouragement to water-works companies by the payment of excessive hydrant rentals, are illustrations of the fostering and development of public service utilities by the public to such an extent as to justify in a large measure the claim that in many cases the allowance of an intangible value is improper as against the public.

A further consideration in the matter of intangible values is the fact that they all partake more or less of the nature of "good will," and the question very properly arises, in the case of a purchase by the public, or of a rate-making valuation: "Should the public be compelled to pay for its own good will?" In the case of such a corporation as a street-railway company in a large city, any value arising from a surplus of earnings is due to the franchise, established business, or going value, or good will of the citizens of that city. This element of value frequently sustains an excessive bond indebtedness. At the expiration of the franchise period the citizens of that city consider a purchase, and are asked to pay, among other things, for their own good will. In view of the attitude of the Federal Courts in the Consolidated Gas Case, and the language of the lower Court in disallowing the item of "good will," which judgment was sustained by the Supreme Court, it is very evident that any attempt to fix arbitrarily a value on such an item in an appraisal is not likely to be supported successfully. The grounds named by the Court are:

Tangible property has a value apart from any franchise or good will value.

The franchise, conferring the privilege to be a corporation, to use public property, to be free from competition, and to enjoy many other privileges, has some value apart from tangible property.

Good will can have no existence as apart from or detached from the franchise conferring the necessary privilege. Such good will (by itself) is not capable of being capitalized and distributed among stockholders.

Citizens are entitled to have gas (or water) because they pay for it, exactly as they are entitled to have clean streets (and, in the same way, police protection or fire protection), because they pay taxes among other things for that.

The Court, therefore, finds that there is no good will value in connection with the gas business in the City of New York, although it is said, elsewhere in the finding, that it is the best, most favorably located, and most prosperous business of its kind in the country.

Judge Tayler, in the Cleveland Railway arbitration, says:

"I allow nothing for good will. A street railway company which has a monopoly, and especially if it has a franchise value remaining, can have no good will value."

Judge Lurton, in the Omaha Water-Works Case, says:

"That kind of good will, as suggested in Willcox _vs._ Consolidated Gas Co., is of little or no commercial value when the business is, as here, a natural monopoly with which he must deal, whether he will or no."

In connection with a consideration of franchise values, the following points are raised by the Federal Court in the Consolidated Gas Cases (157 Fed., 872-879):

"Should a corporation have a right to demand an income return, separable from any return upon its tangible property, from its right to place gas mains in the public streets and maintain them for its private profit, a right which it did not buy from city or state or pay therefor any legal valuable consideration? The Court thinks not, because 'Return can be expected only from investment, and he that invests must part with something in the act of investing.' Does any company invest its franchise in its business? It does not part with its franchise in the same way it parted with money or money's worth in acquiring or creating mains or plants. The investment of property was made, not in the franchise, but under the franchise, and on the faith thereof. The franchise is but a part of the power or sovereignty, allotted to a private person for the benefit of all, and only incidentally given for private emoluments.

"What is the value of a franchise to perform a certain service, under which no money is invested and no service yet performed? What is it worth apart from performance under it?

"Unless it can be seen to possess inherent value entirely apart from the earning capacity of the subsequent investment or from the actual earnings resulting from such investment, the value asserted or claimed is but a duplication of that derived from the use of the tangible property when so invested.

"The concepts of the nature and value of franchises are seen dimly and confusedly because of the failure to distinguish between productive and non-productive property. Land, money, chattels may by industry and intelligence be made productive without a franchise; but no excellence in these desirable qualities can ultimately render a franchise productive without the use of money, chattels, and land in connection therewith, and when the juncture is made the earning capacity of the real and personal property, plus the franchise and plus intelligence and industry, is really no greater than it would be without the franchise, for the franchise has added no producing power to the realty or personalty; it has but authorized their employment in a particular way and protected the owners while so employing them."

The Court emphasized the fact that the particular way in which they are used is in performing a function of the State—in doing a service for the public which the public might do equally well for itself, in the following language:

"I can imagine no more than three ways in which the value of a 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: