The Valuation of Railways

I

IN March, 1913, Congress passed a law providing that the Interstate Commerce Commission should begin within sixty days to make a valuation of all the railways of the United States. The Commission has entered on this work. The public takes these developments as matters of course; yet the project for which Congress has provided, and which the Commission has undertaken, is without a real precedent in any country. Its main purpose is to establish a basis for the regulation of rates; an important auxiliary object is to establish a basis for the regulation of the issuance of stocks and bonds; and the valuation will consist chiefly of a complete inventory of the physical properties. In no other country has a valuation ever been made to establish a foundation for t he regulation of either rates or securities. Practically all of the valuations elsewhere have been steps toward government purchase. In these appraisals consideration has been given to the actual cost and the physical condition of the properties; but preponderant weight usually has been accorded to the net earnings for a period of five years or more immediately preceding. Valuations of railways, similar in their purposes and in the methods employed in making them to that which the Interstate Commerce Commission has begun, have been made by several of the states in this country. But they have been small tasks compared with that which Congress has assigned to the Commission.

Indeed, the valuation of all the railways of the United States is probably the largest detailed appraisal of property ever undertaken. The United States is doubtless the richest nation that ever existed, and its railways represent approximately one ninth of its total wealth. Only its farms and factories constitute classes of industries representing larger investments. The outstanding capitalization of our railways is over $15,500,000,000, which exceeds the combined capitalizations of the railways of the United Kingdom, Germany, France, and Italy; and their mileage is approximately 250,000 miles, which is more than one third of the total railway mileage of the globe, and exceeds by almost one third t he total railway mileage owned by governments in all the world.

The mere extent of the roads to be inventoried, spreading as they do over a very large area, would make the task assigned to the Interstate Commerce Commission protracted, arduous, and difficult. Its difficulty and complexity are augmented by the fact that the principles which should be applied, the factors which should be considered, and the weight which should be given to each principle and factor in valuations of railways and public utilities, are largely unsettled. There are numerous elements, some of small, some of great importance, which some persons contend should be included, and which others contend should be excluded. There are wide differences of opinion concerning the proper methods of appraising even parts of the properties which all agree should be included in the physical inventory. The way in which these disputed points are settled will affect the total valuation by hundreds of millions of dollars. They must be passed on first by the Commission. That the Commission’s rulings will satisfy all concerned is not probable. It is likely that numerous important questions will be appealed to the Federal courts.

II

In framing the valuation law, Congress recognized the fact that there are many open questions regarding valuation. Instead of merely requiring the Commission to appraise the properties, it instructed it to compile also a large amount of information which will show on what evidence it bases its findings, and will be accessible to courts and litigants if the correctness of the findings should become an issue in judicial proceedings. The following is a partial list of the items of information which the Commission must compile: —

The details of the financing and physical development of each property, and its cost to date.

Its cost of reproduction, new.

Its cost of reproduction, new, less depreciation.

The amount and value of the donations of cash, land, and so forth, made to each company by government or private individuals or associations.

The original cost of all lands, rightsof-way, and terminals owned or used for the purposes of a common carrier, ascertained as of the time of dedication to public use, and the present value of the same, and, separately, the original and present cost of condemnation and damages or of purchase in excess of such original cost or present value.

All other elements of value in the property.

The parts of the value of each property assignable to each state.

The Commission is first to make a tentative valuation of each carrier. This is to be sent to the company and other persons directly interested, to the Attorney-General of the United States, and to the governor of each state in which parts of the property are situated, and is also to be published in three daily newspapers in three of the principal cities along the lines of the carrier. In case no protest is made within thirty days the valuation will become final. If protests are entered, the Commission must give rehearings. If there are appeals to the courts, they must ascertain whether or not the findings are correct, and, if they are found incorrect, must refer them back to the Commission for readjustment by it.

General charge of the valuation has been given by the Commission to Commissioner Charles A. Prouty, formerly its chairman, and one of its ablest and most experienced members.¹ A board of engineers to supervise the engineering work involved has been appointed, and an army of engineering and other employes is being recruited by the Engineering Board and the United States Civil Service Commission, to do field-work. It is expected that, later, an advisory board composed of economists and accountants will be organized.

The carriers are required to coöperate with the Commission in making the valuation; and the railways have appointed a committee of eighteen presidents, of which Samuel Rea, of the Pennsylvania Railroad, is chairman. This committee has appointed a committee of engineers to represent the roads in conferences regarding the engineering features. Such is the magnitude of the undertaking that it will hardly be finished in less than five years, and may take ten. It is expected that its cost to the government will be from $10,000,000 to $20,000,000, and to the railways even more.

The principles that should be applied and the factors that should be included, together with the weight that should be accorded to each, and the methods that should be followed, in making valuations of railways and public utilities, are so largely unsettled because the entire theory of valuation as a basis for the regulation of rates is of recent origin — how recent few appreciate. It was never advanced in any country until within the last twenty years; it seems never to have been advanced at all except in the United States; and it is as yet only in the early stages of its development.

Many governments, especially in Cont inental Europe, regarding the construction and operation of railways as a public function, have built and worked them from the start. In numerous other cases, while granting charters to private companies, they have guaranteed them a return on part or all of their investment and exercised strict control over their management. Under a policy of public ownership, or of state guarantee of profits, the government is free to regulate rates as it thinks desirable. The rates of state railways usually have been made too low to cover interest on the investment, the deficits being paid from taxes. The rates of private railways have also in many instances been so regulated as to prevent them from earning their interest and dividends, the governments in such cases usually paying them subsidies raised by taxation.

The situation in England and the United States has been different from what it has been in most other countries; and in each of these countries it has been different from what it has been in the other. In both England and the United States government ownership, and government guarantees of interest and dividends, have been almost unknown. The rule of the English common law was that the person who engaged in a public service had “a right to charge for each separate service that which was a reasonable compensation therefor.’ If a carrier and a shipper fell into litigation over a charge made by the former, the court determined whether the charge was reasonable by ascertaining what was customarily paid for like services under similar conditions; the cost incurred by the carrier in rendering the particular service; the skill with which it was performed; its value to the shipper, and so on. The value of the carrier’s property and the profit made on its entire business had nothing to do with the matter. In the early history of railways in England and America this was the rule applied in determining the reasonableness of their rates. A new element was injected when Parliament in England, and the legislatures in some American states, began to insert in the charters of projected railways, schedules of the maximum rates which they might charge. The maxima thus fixed, being parts of the contracts voluntarily made by the authority giving the charters and the companies accepting them, were necessarily valid. Another, and more important, element was introduced when the law-making bodies began to pass acts fixing maximum rates for railways which already had their charters and were in actual operation.

There could be no doubt of the validity of such legislation when enacted by the English Parliament, for the power of Parliament is not limited by any written constitution. The questions presented when it was enacted by the legislatures of American states, beginning in the ‘Granger’ period of the 70’s, were very different. Their power to act was restricted both by the constitutions of their respective states and by the Constitution of the United States. The legislatures began at the same time to create railway commissions, and these also began to fix maximum rates.

The railways brought proceedings in the Federal courts to get many of these state laws and orders of state commissions regarding rates set aside. In its earlier decisions the United States Supreme Court held that the function of fixing rates belonged to the lawmaking department, of the government, and that its exercise could not be reviewed by the courts. Subsequently it reversed itself, holding that the courts might review legislation fixing rates and set it aside if unconstitutional. Finally, in the Nebraska Rate Case in 1898, the Court laid down for the first time the great principle that ‘the basis of all calculations as to the reasonableness of rates . . . must be the fair value of the property being used for the public convenience . . . What the company is entitled to is a fair return upon the value of that which it employs for the public convenience.’ It was this ruling, made only fifteen years ago, which laid the foundation for all the projects for and discussions of the valuation of public utilities.

III

Numerous theories regarding the way valuations for the regulation of rates should be made have since been propounded. These may be roughly divided into two classes: those holding that valuations should be based chiefly on the amount that the properties have actually cost, provided they have been managed honestly and with ordinary prudence; and those holding that valuations should be based on the present value of the properties.

Actual cost is, of course, the total amount that has been expended on construction and permanent improvements, whether derived from the sale of securities, or from earnings. But some of the advocates of the cost theory believe that there should be included in a valuation only that part of the total investment which has been derived from the sale of securities — in other words, that, investments from earnings should be excluded. Others believe that where investors have not enjoyed, on the average, a fair return throughout the life of the enterprise, and investments have been made from earnings, these, at least to an amount not exceeding the difference between the return the investors have received and what they should have received, should be included. Others go further and hold that investors should receive, on the average, a ‘fair return’ on their out-of-pocket investment throughout the life of the enterprise; and that if they have not done so they should be reimbursed, either by having the deficiency added to the valuation of their property, or by being allowed to receive enough more than a fair return in future to offset the deficiency suffered in the past.

The ‘ actual cost ’ t heory appeals wit h especial force to those who believe that society, and not individual property-owners, or stockholders in corporations, should benefit by the ‘unearned increment’ in land. Of course, if valuations were based on actual cost the unearned increment would be excluded, and rates would be so regulated as to yield no return on it. The ‘original cost ’ theory also appeals to those who believe that investors in public utilities are entitled only to a fair return on their out-of-pocket investment, and that any earnings in excess of this which have been invested should be regarded as held in trust for the public, and should not be included in a valuation to determine what rates the public should pay.

The advocates of present value as the basis of valuation reject the views both of those who believe that the owners of railways and public utilities should not be allowed to benefit by the ‘unearned increment,’ and of those who believe that the owners should not be allowed to receive a return on part or all of the invested earnings. They argue that while such concerns are public as regards the service they render, and therefore may be compelled by regulation to deal fairly with the public, they are as private in their ownership as any other property. The true justification of public regulation, it is contended, is that the quasi-monopolistic nature of public utilities tends to enable them to charge rates that are discriminatory, or higher in proportion than those that could be charged by concerns operating under competitive conditions, and that regulation is necessary to prevent this. But because regulation is necessary to keep publicservice corporations from charging the public more in proportion than competitive persons or concerns, is no reason why regulation should deny to them rights and advantages enjoyed by others persons and concerns. To do so would be not merely to prevent them from dealing unfairly with the public, but to deal unfairly with them. Therefore, it is concluded, it would be neither equitable nor expedient for society to appropriate the unearned increment of railways and public utilities, while permitting the owners of city real property, mines, farms, and so on, to retain and benefit by the unearned increment.

As to the treatment of invested earnings: How much the net earnings of any concern will be depends not only on its rates or prices, but also on the efficiency with which it is managed. Now, suppose that two railways, represent ing the same out-of-pocket investment, have been operated in the same territory and have charged approximately the same rates. One has been very efficiently managed, and has enjoyed large surplus earnings which have been invested in its property. The other, while operated with ordinary prudence and skill, has not always earned a ‘fair return’ on its out-ofpocket investment, and has had no surplus earnings to invest. If the two roads were evaluated at their actual cost the valuation of the better-managed, in which there had been invested surplus earnings, would be the greater. If they were evaluated at the amounts of capital the owners had invested out of their own pockets, the valuations would be the same. If they were evaluated on the theory that investors are entitled to a fair return, no more and no less, and that any deficiency in the return should be added to the out-ofpocket investment, then the valuation placed on the road which had been the less skillfully managed, which had earned no surplus to invest, which had even failed to earn a fair return, and which had actually cost the less, would be the larger. Valuation based wholly on what railways have cost would, it is contended, penalize economical and efficient construction and operation; and this would be especially true if investments made from earnings were partially or wholly excluded from consideration.

It would appear that even if the cost theory of valuation were satisfactory as a matter of economics, it could not be adopted as a matter of law. The Federal courts, from the inception of the theory of valuation for the regulation of rates, have held that it should be based, not on the cost of the properties, but. on their present value. Some consideration of why the courts originally ruled that ‘fair value’ was the basis for calculating the reasonableness of rates will indicate why it is the present value, and not the cost, of the properties, which is held to be their fair value.

IV

The Fifth Amendment to the Constitution of the United States prohibits the Federal government from taking private property without just compensation. The Fourteenth Amendment prohibits any state from taking property without due process of law, or from denying to any person within its jurisdiction the equal protection of the laws; and it is held that these provisions, as well as those of the Fifth Amendment, require the payment of just compensation when property is taken for public use. It is these constitutional provisions which protect all persons from having their property taken unjustly by the state or national government under the power of eminent domain. And it was behind these that the railways took refuge in the Nebraska Rate Case. The rates fixed by the State of Nebraska, t hey argued, were unremunerative. To compel them to accept unremunerative rates would be to destroy the value of their properties. Thus to destroy the value of the properties would be to confiscate them as effectively as to condemn them and take them without just payment, and was, therefore, unconstitutional. It was this line of reasoning which the Supreme Court accepted. In other words, it held that the regulation of the rates of a railway so as to destroy its fair value to its owner, leaving to him only the empty title, was equivalent actually to taking possession of and title to the property under the power of eminent domain without paying its fair value.

The reasoning and language of the Federal courts indicate that to them ‘fair value’ means substantially the same thing in a rate as in a condemnation case. ‘Now,’ said Justice Brewer, in the opinion of the Circuit Court in the Nebraska Rate Case, ‘if the public was seeking to take title to the railroad by condemnation, the present value of the property, and not the cost, is that which it would have to pay. In like manner, it may be argued that when the legislature assumes the right to reduce rates, the rates so reduced cannot be adjudged unreasonable if under them there is earned by the railroad company a fair interest on the actual value of the property.’ But the ‘fair value’ which must be paid when property is condemned is not its cost, but its present value. It follows that the fair value which is the proper basis for calculating the reasonableness of rates is the present value.

The courts have said that the actual cost and many other elements should be considered, but merely as aids to ascertaining the present value. If the present value of a property is less than its cost, the owner must lose by its depreciation; if more, he gains by its appreciation. ‘We concur with the court below,’ said the Supreme Court of the United States in the Consolidated Gas Case in 1909, ‘in holding that the value of the property is to be determined as of the time when the inquiry is made regarding the rates. If the property which legally enters into the consideration of the question of rates has increased in value since it was acquired, the company is entitled to the benefit of such increase.’ And in the Minnesota Rate Case, decided in 1913, it said: ‘The property is held in private ownership, and it is that property, and not the original cost of it, of which the owner may not be deprived without due process of law.’

However, there is one important difference between making a valuation of property preliminary to dispossessing its owner and giving him its equivalent in cash, and making a valuation for fixing reasonable rates. The market value of a property depends on its earning capacity; and when property is taken under the power of eminent domain it is approached from a commercial standpoint. Therefore, the chief consideration is earning capacity, and ordinarily the chief measure of earning capacity is the amount of profit actually earned. In valuation for the regulation of rates, on the other hand, t he fundamental assumption is that the chief measure of the reasonableness of the rates is the ratio of the net earnings to the value of the property; and the immediate purpose of the valuation is to ascertain this ratio. Obviously, in such valuation little or no weight can be given to the net earnings.

This presents a great obstacle to the valuation of some public utilities. For example, in the case of express companies, — which under the provisions of the Interstate Commerce Act are common carriers, — the exclusion of the net earnings from consideration raises a serious difficulty, because the investment in and value of the physical facilities used are so small compared with the investment in and value of the organization built up and maintained to handle the traffic. In the case of a railway, on the other hand, the physical property is a very large part of the whole property, and represents a very large part of its entire value. The capacity of the physical property determines how much traffic can be handled, and, largely, therefore, how much gross income can be earned. The investment that has been made in the physical property, the skill with which it has been developed, the condition that it is in, largely determine whether the expenses of operation will be relatively high or low, and, therefore, whether the net earnings will be relatively low or high.

In the ascertainment of the present value of its property a railway or public utility is entitled to have considered, not only its physical capacity and present condition, but also, of course, the value of the real estate owned by it and constituting part of its physical property. On the whole, the best measure of the various elements of value just mentioned is the probable cost of reproducing the physical property. Therefore, the cost of physical reproduction has been accepted by engineers, economists, and courts as ordinarily the principal factor in valuation for the regulation of rates.

But when the cost of reproduction has been thus accepted, the way in which a valuation should be made has not been set tled. It is generally agreed that in estimating the cost of reproduction of roadway, structures, and equipment, the prevailing unit prices of materials and supplies, and the prevailing wages of labor, should be used; the thing to be ascertained is what grading would cost per yard now, not what t he grading done in the past actually did cost; it is what would have to be paid for freight cars now, not what actually was paid for those that are in service. There is, however, hardly an element of the physical property which at any given time is not worth either less or more than it would cost to replace it, new. Rails, ties, cars, locomotives, and so on, begin to wear out or to drift toward obsolescence as soon as they go into service. Therefore, it is generally conceded, and the Supreme Court of the United States has held, that some deduction must be made from the cost of replacement, new, of all such parts of the physical property in arriving at its present value. On the other hand, there are some parts which increase in value. For example, for periods of five to ten years after the construction of a railway its roadbed becomes more solidified and better adapted to its function, if the property is at all well maintained. It has been contended that no allowance should be made for this solidification and adaptation, because it is largely due to the work of the operating department, and the expense incurred is charged to operating expenses. But this contention is made on the theory that valuation should be based on actual cost; whereas, as has been seen, it must be based on present value. It apparently follows that an allowance should be made for solidification and adaptation, although this is unsettled. It also follows that value created from earnings must be included.

As to the so-called ‘unearned increment,’ the Supreme Court of the United States has indicated that it must be given weight. When a railway acquires land for right-of-way or terminals, whether it gets it by voluntary sale or condemnation, it ordinarily must pay from one and one half to several times as much as would have to be paid if the land were acquired for almost any other purposes. This is because the severance of the land acquired, and the construction of the road, cause damage to adjacent property, and because land so situated that a railway must buy it to carry out plans for construction or improvements, attains a monopoly value. Following the reproduct ion theory to its apparently logical conclusion, many economists, engineers, railway commissions and courts have held that railway land should be included in physical valuation at what it would probably cost the railway to acquire it now. In the Minnesota Rate Case, decided in June, 1913, the Supreme Court of the United States seems, however, to have established the principle that railway land should neither be inventoried at what it cost originally, nor at what it would cost the railway to acquire it now, but at its present market value for ordinary purposes.

While it is established that the cost of physical reproduction, less depreciation, is the most important element in the valuation of public utilities, it has been contended, and t he Federal courts have held, that t here are other important elements which should be given weight. This view seems logical and sound in principle. The immediate purpose of valuat ion is to ascertain the entire present value of the property. The net earnings cannot be considered because they result from the application of certain rates, and the ultimate purpose is to ascertain whether these or some other rates would be the more reasonable. But, after all, the true value of most property does depend on its earning capacity, and, therefore, while net earnings cannot be accepted as a basis for valuation, there should be considered all factors, except the rates charged, which go to make up earning capacity.

Now, while the amount of business that can be handled, and the economy with which it can be handled, depend on the characteristics of the physical plant, the amount of both gross and net earnings actually secured depends not only on these things and on the rates charged, but also on the amount and nature of the traffic actually secured and handled; and the amount and nature of the traffic, and the economy with which it is dealt with, depend on the skill with which the concern is organized, and the ability and energy with which it is managed. It follows that the organization of the company, and the volume and character of its established business, are important elements in its present value.

The courts seem to have determined that ordinarily no allowance can be made for franchises in the valuation of a public utility. The various elements of value just mentioned are, however, sharply distinguishable from franchise value. They constitute ‘going value’; and as ‘going value’ is just as much a part of the true, present value of a public utility as the value of its physical plant, it would seem that some allowance should be made for it. Certain of the public utility commissions, notably the Railroad Commission of Wisconsin, do this; others refuse to do it, and decisions of the courts, including those of the United States Supreme Court, are conflicting. It has been almost uniformly held, however, that going value must be considered in condemnation cases; and it seems probable that this rule will finally prevail in rate cases.

V

Having in mind the bases upon which the valuation, which the Interstate Commerce Commission has begun, probably must be made, to what results does it seem likely to lead?

For many years it has been alleged that the railways of the United States are greatly over-capitalized, and charge excessive rates in order to earn and pay a return on their watered securities. This allegation is vigorously controverted. Defenders of t he railways concede that some of them have been over-capitalized. But they point out that a few companies have retired parts of their original capital, that many have made large investments from earnings, that there has been a large increment in the value of the land owned by railways; and it is therefore argued that the value of the railways as a whole now equals or exceeds their total capitalization. As the return paid on the total capitalization is, and always has been, small, the conclusion has been drawn that, on the whole, railway earnings and rates are and have been, not too high,but too low. It is chiefly with a view to settling this disputed point, and to adopting a policy of regulation harmonizing with the facts found, that Congress has required a general valuation to be made. How much, then, will the valuations of individual properties, and the valuation as a whole, probably amount to as compared with the capitalizations of the individual properties, and the capitalization as a whole? And what use probably can and will be made of the valuations of individual properties and of the valuation as a whole? These are questions which no one can answer with any degree of positiveness. There are, however, some facts and conditions on which a forecast can be predicated.

The railways formerly opposed a general valuation. But their opposition declined; and the legislation finally passed by Congress encountered practically no opposition from them. This change in their attitude was due to the results of various valuations in recent years, some of them made by the companies themselves to introduce as evidence in rate cases, others made by various public-utility commissions and other public authorities. Among the states which have made valuations of railways within the last decade are Washington, South Dakota, Michigan, Minnesota, and Wisconsin. In these states the valuations of some roads were greater, and of some less, than their capitalizations. In New Jersey, likewise, the valuations of some railways were greater, and of some less, than their capitalizations. The investigation being made by the Interstate Commerce Commission, like those already made by various states, is certain to show that some railways are earning and paying large returns on the value of their properties, while others operating in the same territories and charging the same rates are earning and paying very small returns.

On the theory underlying valuation, the public may reduce the rates of any railway which is earning more than a fair return. But, on the same theory, the owners are entitled to advances in the rates of any railway which is earning less than a fair return, if it is being managed honestly and wit h reasonable prudence. It is axiomatic, however, that the rates of railways operating in the same territory must be the same. Otherwise, all the competitive traffic will go to the one whose rates are the lowest. Therefore, if the rates of the railways earning more than a fair return were reduced, t he rates of t hose earning only a fair return or less would also be forced down, making their returns much less than would be fair. As a matter of fact, if rates were so regulated as to restrict the strongest roads in each territory to net earnings of 6 or 8 per cent the weaker roads would all be bankrupted. This would be neither just to railway owners nor expedient for the public. On the other hand, if the rates were so fixed as to enable the weaker lines to earn fair returns, they would be made so high as to enable the strong lines to earn very large returns. These conditions present a perplexing situation.

The Interstate Commerce Commission has said that the conditions as a whole should be considered, and the rates regulated with reference alike to the needs of t he weaker lines of a group and the prosperity of the stronger. If it adheres to this view doubtless it will prevail. The Commission possesses legislative discretion, and, therefore, while it probably has power to reduce rates until they verge on confiscation, it is not legally bound to make them any lower than it deems consistent with justice and public expediency.

Assuming that the situation will be dealt with as an entirety, and not with reference to the position of individual railways, what is likely to be the general effect of the valuation on rates?

The aggregate net capitalization of the railways in Washington, South Dakota, Michigan, Minnesota, and Wisconsin — net capitalization being arrived at by eliminating the duplication in the gross capitalization caused bv intercorporate ownership of securities— amounted to $1,210,999,000, and the estimates of the cost of reproduction, new, of the physical properties aggregated $1,211,806,500, while the estimates of present value — arrived at by making deductions for depreciation — amounted to $1,035,089,184. The total gross capitalization of the seven principal railways in New Jersey was found to be $357,346,000, and their total valuation, $361,157,000. The largest masses of value in railway properties are concentrated in the terminals in large cities, such as New York, Chicago, Philadelphia, Pittsburg, and St. Louis; and most of the state valuations referred to have been made in states where there are no very large terminals. In most of these valuations no allowances have been made for going value. Yet the state valuations usually have approximated the net capitalization assignable to the railway mileage evaluated.

Let us approach the matter from another angle. The railways earning more than $100,000 a year each reported to the Interstate Commerce Commission that up to June 30, 1912, the investment made by them in road and equipment was $15,895,657,969. The gross capitalization reported by the same roads was $19,533,750,802. The Commission has not published any figures regarding the duplication in t he capitalization in 1912 caused by the intercorporate ownership of securities; but in 1911 this duplication exceeded $4,000,000,000. It is, therefore, safe to assume that the net capitalization of these roads in 1912 did not exceed $15,500,000,000. This is substantially less than the amount which they reported had been invested in their properties.

On the whole, the available evidence points to the conclusion that the aggregate valuation of the railways will equal or exceed their aggregate net capitalization. If this should be the case, what would it indicate as to whether the earnings and rates as a whole are reasonable or unreasonable? The net operating income of all railways earning more than $100,000 in 1912 was $756,000,000. This was less than 4 per cent on their gross capitalization and less than 5 per cent on their net capitalization; and not all of their operating income was paid out in return to capital. No interest was paid on 7.5 per cent of the total amount of funded debt outstanding (other than equipment trust obligations), and the average rate of dividend paid on stock was but 4.73 per cent. On this showing it could not be held that either the net earnings, the return to security-holders, or the rates generally, were excessive. An opposite conclusion would be indicated.

It is commonly assumed that once a valuation has been made it can be kept up to date and available for rate cases merely by adding to it from time to time the additional investments made in the properties. It is questionable if this is correct. After a valuation has been made there may be not only additional investment, but also changes in the unit costs of labor, and of materials and supplies, in the value of land, and in the ‘going value’ of the property, all of which will affect its ‘fair present value.’ Therefore, the increase in value might be much more or much less than the additional investment. It would seem, consequent ly, that if valuation is to be used for the regulation of rates, there must be complete revaluations from time to time.

Some persons regard with alarm the proposition that not only additional investment, but changes in value due to other causes, must be considered. They fear the increment in land will cause railway valuations to mount higher and higher, thereby causing rates to be steadily advanced. Probably these apprehensions are not well founded. Increases in the value of land are not fortuitous; and if the value of that owned by railways continues to advance, this will be due to the growth of population and industry. If population and industry grow, their growth will cause an increase in the volume of railway traffic. The railway business being one of increasing returns, each increase in the volume of traffic, other things remaining equal, reduces the operating expenses and fixed charges for handling each unit of traffic. In the case in quest ion, all other things would not remain equal. The increment in the value of land would increase the amount of return that would have to be paid to railway owners. But the effect of this on the unit cost of handling the traffic would be very much less than the effect of the increase in the volume of the traffic. At present, 73.5 per cent of the outgo of the railways is for operating expenses and taxes, and less than 18.5 per cent is for return on investment. Now, while the increase in the volume of traffic would tend to reduce the operating expenses, taxes, and fixed charges per unit of traffic, the increment in the value of land would tend to increase only the relatively small part of the outgo per unit represented by fixed charges. Consequently, if the wages and the prices of materials and equipment entering into operating expenses did not increase while the volume of traffic was increasing, the value of the property and the return paid on it might increase, while passenger and freight rates were actually reduced. The operating expenses of the railways of the United States are so very much larger than their net earnings or the return paid by them on capital, that anything which affects expenses produces a very much greater effect on rates than anything which affects to a similar degree net earnings and return on investment.

VI

While the main purpose of making the valuation is to establish a basis for the regulation of railway rates, an important auxiliary purpose is to lay a foundation for the regulation of securities. There have been various forms of regulation of securities ever since the railway was invented. Sometimes the law has forbidden the issuance of stock or bonds except for cash, property, or valuable services. Sometimes it has provided that the amount of bonds should not be more than one half or one third as great as the amount of stock. Sometimes it has provided that bonds, or even stock, should not be sold for less than their par value. Sometimes it has prohibited securities from being sold for less than their market value. Sometimes it has specified that securities should be issued only for the acquisition of property, the construction of new or the improvement of old lines, or the refunding of outstanding obligations. In several states the railways and public utilities are required to get the permission of public-utility commissions before issuing any securities. The plain intent of practically all legislation on the subject has been to prevent securities from being issued without consideration, or to prevent the capitalization accumulated from exceeding the actual investment made. There is apparently no question as to the validity of state legislat ion intended to make the securities issued correspond to actual investment; and probably Congress might legislate regarding the utterance of securities, and delegate to the Interstate Commerce Commission authority to regulate it.

In no case, however, does there appear to have been legislation to make the securities issued correspond to the valuation of the property. If Congress and the Commission should attempt to do this their action would be unique, and great legal and practical difficulties would be encountered. The values of all roads will be increased by natural increment and by investments of both new capital and earnings. Are those whose valuations are found to be about equal to their capitalizations to be allowed thereafter to capitalize the value added by all these causes? Are those whose valuations exceed their capitalizations to be allowed to issue stock dividends large enough to make the capitalizations and valuations equal? Finally, if the securities of the roads whose capitalizations exceed their valuations were all issued legally, can they be compelled to recall them? It may be suggested that the lastnamed class should at least be forbidden to issue more securities until their valuations and capitalizations correspond. But if this were done the value of their properties could be increased subsequently only by the investment of earnings and by natural increment. If the net earnings of a road thus situated were restricted to a fair return on its valuation and it chose to pay them all out to its security-holders, it could hardly be prevented from doing so. In that case no expenditures whatever for improvements would be made. Natural increment might ultimately bring such a road’s valuation up to its capitalization; but meanwhile the public would suffer from its backward development and its deficient service.

These and other considerations indicate that valuation can hardly serve as a satisfactory basis for the regulation of securities. The Railroad Securities Commission appointed by President Taft, after a very thorough investigation, concluded that no legislation regarding the issuance of securities was desirable except provisions for giving publicity to the facts as to their sale and as to the disposition of the funds derived from them. Legislation which went further than (1) to prohibit securities from being issued except for a valuable consideration, and (2) to compel all the money derived from them to be invested in the properties, would be of very doubtful expediency.

VII

The foregoing discussion might give the impression that the valuation of railways probably will have no results of importance. Such an impression would be erroneous. The valuation is sure to have some results of importance. It may have results of very great importance. If its total amount should not vary widely from the total investment in road and equipment or from the net capitalization, it might satisfy the public that, on the whole, the railways are not over-capitalized, as has been represented, and might cause the public to adopt and the railways to accept a firm, but consistent and liberal, policy of regulation. These would be results of very great importance.

The expectations expressed in this article as to what the total valuation will amount to may, however, prove illusory. It is conceivable that it may be much less than the total outstanding capitalization of the railways, and may, therefore, lead to sweeping reductions of rates. This would throw many railways into insolvency, and seriously impair the financial strength of others. The result would be that needed improvements in existing lines, and needed construction of new lines would, if the policy of private ownership were continued, be hindered, because capital for them could not be obtained. The public might then decide that it would be best to take the railways over at their valuation and operate them as a government function.

It is conceivable, on the other hand, that the valuation may very much exceed the total outstanding capitalization. This would show that the present net earnings and rates of the railways are lower than they are legally entitled to receive. The roads might then make substantial advances in their rates. This would be a result the very opposite of that anticipated and hoped for by most of those who have advocated valuation, and by a large part of the public, and they might be disappointed and indignant. If the valuation should greatly exceed the net capitalization this would be due largely to the unearned increment in the railways’ land. Those who were disappointed with the results might say that if under private ownership the value of the properties was going to continue to increase in excess of the investment made in them, and this increased value was going to be made a basis for advances in rates, it would be best for the public to acquire the railways and secure for itself all the benefit of the increases in their value. Such developments would be very far from showing that the results of the valuation were unjust, or that government ownership was desirable. But such an argument as that just outlined might, nevertheless, fall on many hospitable ears. And the owners and managers of the railways might not, in such circumstances, vigorously oppose government purchase, for in case of purchase the owners doubtless would be paid the high valuation that had been put on their properties.

The valuation being made is, therefore, fraught with great possibilities. Whatever its aggregate amount may be, compared with the aggregate capitalization of the railways, it is likely to have important results. And these are quite as likely to be results that are unexpected as those that have been generally anticipated.