Part 22

"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.

"Commercial Valuation of Railway Operating Property in the United States: 1904." Bulletin 21, United States Bureau of the Census. Contains an exhaustive discussion of sundry methods of valuation. The most complete series of papers on valuation yet published.

_The Chicago Appraisal._—

Report to the Common Council on Railroad Valuation. B. J. Arnold, M. Am. Soc. C. E., M. E. Cooley, and A. B. Du Pont.

_The Michigan Appraisal._—