Part 37

The statement that no appraiser would be justified in placing a going concern 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 commercial value in excess of the physical property, is questionable. "Commercial value" is not exactly synonymous with "going concern value," for, as usually considered, the term "going concern value" represents the difference between a dead structure and a live one. A property might be compelled to operate temporarily at rates insufficient to return the legal rate of interest on the physical value of the property, and while this condition continued, its commercial value would be less than its physical value, and yet this same property is worth more while running than if operation ceased and the business was allowed to die.

HALBERT P. GILETTE, M. AM. SOC. C. E. (by letter).—In common with others who have written on the subject of appraisals, the author omits consideration of one of the most important elements of the cost of producing the property of a public service corporation, namely, the development expense.

Development expense is the deficit in "fair return" on the investment during the early years of operation, while the business is being developed to a point that will yield a "fair return" on the investment. Unless this development expense is charged to the capital account as fast as it occurs each year, it should draw compound interest up to the end of the development period. Development expense might be regarded as a part of the non-physical value of a plant, and a few years ago the writer so regarded it. Latterly, however, he has come to see that it does not differ one iota in principle from "interest during construction," and, therefore, is properly a part of the cost of production or of reproduction of the property. During the construction period, interest on the investment is charged, and properly so, as a part of the physical cost. Does this interest cease the day after operation begins? Not a whit. The owners of the property are entitled to a fair interest—a "fair return"—on their money, from the day it is invested. At first they receive it in the form of "interest during construction," which is charged to capital account. After operation begins they must either be allowed to earn more than a "fair return" during the fat years following the development period, or the deficit below a fair return incurred during the development period must be treated exactly like "interest during construction" and added to the capital account. If public service corporation managers have chosen the first of these two methods, it does not relieve the appraiser of the duty of adopting the second method; for the object of appraisals for rate-making purposes is to limit capital to a "fair return" on the investment. In brief, if there are to be no "fat years," then every "lean year" must be credited with its deficit as fast as it occurs.

This, the writer concedes, is a radical departure from such precedent as 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.