NECESSARY ELEMENTS FOR WATERWORKS VALUATION*

NECESSARY ELEMENTS FOR WATERWORKS VALUATION*

The work of valuing the property and plant of public utility corporations in this country is coming increasingly to be of importance since the realization on the part of capitalists and the public that the courts are more and more interpreting the relations of the public utility company and the public as a quasi-partnership. It is now a well-established rule that moneys devoted to the use of the public in furnishing water, gas, electric light, telephone service and transportation are to be differently treated from capital devoted to a private enterprise under free and unrestricted competition. It has been repeatedly pointed out by the courts, for instance, that the rates to public utility corporations must constitute a fair return upon the capital properly and usefully invested for the purpose of serving the public, if at the same time their decisions confirm to the municipality or the state the right to regulate such rates as they do. It is obvious that it is intended and expected that inordinate profits in this field of activity are not to be permitted on the one hand, and as a corollary to this conclusion it is necessary that moneys devoted by investors to public purposes cannot be subjected to unreasonable losses.

One of the most fruitful causes of confusion in considering the valuation of public utilities lies in the fact that most people fail to distinguish between properties serving the public exclusively under a franchise granting special privileges, in which there can be no real competition, and a manufacturing plant that has no such privileges, and that supplies the needs of the people in some line where private competition has free play and in which the use of the public property, such as streets and highways, does not enter. Light on this distinction is had by studies of the reasoning of such courts as have made careful examination into the valuation of public utilities for the past dozen years or so. This study has resulted in the preliminary confirmation of methods and practice for the determination of the valuation of such properties, whether for the purchase of the plant by the city or predication of fair return upon capital invested.

There are at least and perhaps four methods of valuing a public utility property such as a water plant, all of which the courts have held are proper under certain circumstances:

First—The method of reproducing the property and business at present cost, lessened by any depreciation which the original plant or business has suffered.

Second—The method of ascertaining the actual past investment from the books of account, in which case neither depreciation or appreciation are usually considered.

Third—The method of determining the value by the market price of stocks and bonds when it is certain that an active and representative market can fairly be said to exist.

Fourth—The method of valuing from the standpoint of a willing seller to a willing buyer, who as a judicious investor judges the plant by a careful analysis of its income, privileges, duties and the future prospects of the city it serves all without going greatly into cumbersome detail.

The first method has been the one which the courts and appraisers have most commonly used and proceeds on the theory of an imagiuery duplication of the property at prevailing prices for materials and labor, This method necessarily involves, as a mental process, a re-creation, step by step, of what may be termed a “conceptual starting plant.” that being gradually built up as a mental picture by the aid of experience, local information and trained imagination will as a process of mind eventually duplicate in its final form and detail the existing or going plant.

It will be obvious from this definition that, while this method at first glance apparently has the charm of simplicity, it is to be doubted if this seeming simplicity really exists in practice. The method logically requires many refinements, some of which are quite complex.

The second method of valuation of a property before mentioned—that of past cost—is often impossible of fulfillment by reason of lack of carefully kept accounts from the beginning of the enterprise. Where these exist, and where it is known that they have been carefully kept, they form an adequate basis upon which to predicate values, for it is obvious that nothing can be more fair, either in the fixing of rates or the transfer of a property than consideration of the actual cash investment in that property from the beginning of its history, especially when it is known that it has been honestly and wisely made. Few companies, however, are able to produce such data as this. Changes in ownership, carelessness in accounting and other uncertainties usually history of the plant, however desirable it might render it impossible to give a connected financial be to do so.

the third method of determining values before mentioned, that of proceeding upon the market price of stocks and bonds when an active and representative market can fairly and certainly be said to exist, is one which is obviously rarely possible in the consideration of public utilities. For waterworks securities at least active and representative markets have not existed for many years. This class of securities has been largely in disfavor with the general investing public, due to the oversanguine prospectuses of the original promoters, the disappointments in realization of reasonable profits often to the hostility of the public, and finally the entire neglect on the part of the investor or promoter to realize the importance and significance of depreciation or to provide therefor in any way. I do not know in recent years of any case where there could be said to have existed a fair market value of the stocks and bonds of a private waterworks company which gave any reasonable indication of the value of the property. The fact of the matter is that the owners and investors themselves usually have little idea as to what is the true value of the investment which they are handling, except, perhaps, in a general way, upon a basis of its past cost or available net revenues.

This brings us to the fourth method which I have mentioned, which, while valuable in all ordinary business intercourse for the purchase of competitive properties, does not afford that satisfactory and definite conclusion when dealing with public utilities which is desirable, for the reason that with the regulation of rates by the municipality or state there is afforded the company no opportunity to make good in the future the deficiencies or misfortunes of the past. This fourth method, however, in some cases is a desirable method to investigate in connection with the first method as a sort of a review or check, for it sometimes gives us an insight into the question of rates in a way that is illuminating and convincing.

Having, therefore, outlined briefly these four methods of valuing properties of this character, and knowing that probably nine-tenths of the time, either through the influence of the courts, the owners or the public, we are obliged to fall back upou the method of valuation by reproduction, it may be desirable to note the necessary elements to be considered in the method of reproduction. First and foremost, it is obviously necessary to prepare a statement of the physicall property in such manner that the estimator can re-create it in his imagination in a practical and humanly possible manner. Such a statement is usually called an inventory, a name which is rather a misnomer, for a proper statement of this kind, far from being an inventory of the character that such a name would usually imply, is much more. Inventories (so-called) are generally lists of physical property, such as tools or stock, and no more; but the inventory of which we here speak is in the nature of a general plan and specification, and yet even more than this, for it is a definition of all of the known facts with reference to a property, its history, the difficulties which it has surmounted, the structures which have had to be temporarily erected and destroyed in order to bring it to its completed shape—all these things must be fully outlined in such a way that the estimator can retrace as an unfolded panorama in his mind step by step each stage in the progress of the plant and its progress from the original concept in the mind of the projector through the preliminary production of plans, the expenditure of capital for promotion. the time necessary for construction, the orderly introduction into his outline of each structure in the place and time when it would naturally be begun and finished, up to the final completion and placing into operation of the finished works and obtaining the necessary business or income therefor.

Such a statement, while called an inventory, is obviously a specialized compilation of the most important character and should be best prepared by those familiar with its purpose and intent. Once prepared it becomes extremely valuable to a company in the large amount of” information which it will afford both as to the present condition, general arrangement and detailed dimensions of all underground construction, as well as past history, the difficulties under which the structure was put into shape for useful service. It desirably includes photographs not only of present construction, but of past or original construction ; tables showing growth, with particular attention to the age and general condition of each part; plats showing the character of the soil and other special difficulties of construction in the locality; tabulated statements of account, variety, weights, quantities or other units to be computed upon; brief history of the original difficulties, such as treacherous foundations, wet soils and other unusual conditions; full mention of all structures and plant appliances which were necessarily in the original construction, but which may have disappeared when their useful purpose was ended; brief account of the structures or machines which, have depreciated by changing conditions, and the reasons therefor; also special information tending to show the possible future life of the different parts or structures, and any information that will throw light upon the appreciation or depreciation of the property by reason of the fact that its present reproduction will he more or less costly than the original reproduction would have been. These are only hints as to the variety of information which is to be contained in a statement of this kind as against what is commonly designated as an “inventory” merely.

With such an inventory or statement in hand it is next desirable to engage an estimator who has the following requirements:

First—Broad experience in the construction or observation of waterworks of all classes in various localities, large or small; also experienct in the operation of waterworks properties.

Second—It is desirable that an estimator should have what is known as “the proper frame of mind”: that is to say, experience with all of the various points of view which are thrust sometimes so unceremoniously upon men charged with this kind of responsibility. He should desirably have served cities as well as water companies, if not in equal number, at least sufficiently often on opposite sides so that he can appreciate all points of view that come with the problem. Without this experience he can hardly hope to be able to preserve that balance and equanimity of mind which is so necessary to fairness.

Third—He should possess a considerable and vivid imagination, trained though it may have been into practical channels by reason of long experience. The great temptation of the inexperienced estimator in reproducing plants and properties is to “short-cut”—that is to say, having before him the completed works and efficient hindsight only as to the apparent ease with which it was put into place, he is obviously tempted to rub a sort of an “Aladdin’s lamp” in his mind, and lo, the works are completed at not only a very minimum of cost, but sometimes at an impossibly low figure. The “frame of mind” which an estimator should have when he attacks the problem is that he, himself, is charged with the responsibility of completing a works like this, and that his reputation is at stake in making a preliminary budget which shall fairly and accurately cover the cost of the plant, with all its contingencies in the future. No other frame of mind than this will produce honest, satisfactory or just results.

Appraisal boards charged with the duty of determining the value of plants, either for ratemaking or sale, are customarily composed in a bipartisan manner: that is to say, franchises usually provide that the city shall choose one member, the company another, and they, two, in turn choose the third member of the board. There is probably no more vicious and improper method of selecting appraisers that could be devised. The very attitude of mind which is induced by such an arrangement is that of a partisan on the part of at least two of the members of such a board. Only trained and experienced men of considerable character can successfully overcome this unfortunate temptation of such a position and throw off from themselves the idea that they are there to represent a client. Where this method of selection is pursued the estimator falls easily and naturally into the vicious attitude of looking at the problem from a one-sided standpoint in the unhappy desire of better serving those who appointed him. The result often is that the two estimators appointed as representatives generally fall apart little by little, and as the work proceeds the breach growers wider. Meanwhile the the third appraiser, or the umpire as he unfortunately becomes, is obliged to settle differences between them, or to harmonize them in such a manner that satisfies neither, the problem nor the remainder of the board and eventually he becomes himself a sort of sole appraiser upon whom the responsibility devolves, under the most unfortunate and uncpmfortable circumstances, of settling the final value. By the time the valuation is completed feeling often reaches such a point that no calm, dispassionate review of the whole valuation is possible, and the appraisers part with the feeling that they never want to enter into another appraisement of the same character

Now this whole attitude would be easily changed if franchises could only contain a clause that such boards are to be selected and appointed in such a way that no one member shall be considered, or shall be the representative of the interests either of the city or of the company. This can be accomplished in a number of ways, either by representatives of the city and the company meeting and canvassing the names proposed, or appointing representatives to do so in such a manner that the appraisers selected are entirely unaware and even idifferent as to whose influence placed upon them their responsibilities. When properly appointed in this way such a board produces harmonious study, disinterested discussion of each mooted point, and the results are reached in less time without friction and with greater fairness. A dispassionate review of the whole work upon its completion is possible, and the entire energies of the board are concentrated upon the real subject in hand rather than upon the unhappy necessity of watching to see that individually they are not perhaps influenced by some bias originating usually in the minds of the clients or their attorneys whose interests are at stake. Engineers are not naturally partisans. Their profession tends to develop the open mind, and it is unfortunate to find them ever obliged to accept positions of partisanship, for they are not naturally adept at the practice.

A carefully prepared inventory and statement of a waterworks property (whether municipally or privately owned) and a valuation thereon is of great service in many ways. In the ordinary conduct of such a property, it is essential to have the officers and employes of the plant have a complete knowledge of the works under their charge, as well as its past history and present condition. Such knowledge affords a starting point for improvements, changes, or alterations, which are so continually necessary in any growing waterworks serving a prosperous city. The value of a plant and property is sometimes a surprise to the owners, and almost always an unknown quantity of any municipality. It affords a basis for bonding (where privately owned) or for writing off properly and equitably depreciation, either when publicly or privately owned. Carried forward from year to year by correctly audited additions to the capital account, it becomes unnecessary to make further valuations in the near future, such values become increasingly useful as a basis for sale, for computing fair return, or for observing the ordinary operation of the plant, or various rating matters. Private companies everywhere are appreciating these conditions: municipalities in general have not yet fully awakened to them. It is believed that in a few years no well-conducted private companies will be without their complete inventory and valuation, and that municipalities will before that time begin to wake up to the fact that they, too, have no knowledge as to the real value of the property which they are operating, or the proper amount to write off for its depreciation, or any scientific basis upon which to predicate their rates.

*Paper read at the meeting of the Indiana Sanitary and Water Supply Association. Indianapolis. February 25, 1910.

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