Cost, capitalization and estimated value of American railways; an analysis of current fallacies

Front matter

Glass tiE z x3

Book >I1 nffm^i

COST CAPITALIZATION

Introduction

Why Official A'aluation of Railway Property is Desirable

In numerous official and unofficial utterances, President Roosevelt has made it clear that he has lent a more or less complaisant ear to the theorists and agitators who for many years have been clamoring for government valuation of the property of the railways of the United States represented by their stocks and bonds. Tnis clamor was put in concrete shape in the amendment to the Hepburn Act introduced by Senator La Follette, which reads :

''That the Commission shall estimate and ascertain the fair value of the property of every railroad engaged in interstate commerce, as denned in this act, and used by it for the convenience of the public."

That the demand thus formulated was not original with the senator from Wisconsin is proven by the discussion of its practicability by Professor Henry C. Adams in his first report as Statistician to the Interstate Commerce Commission for the year ending June 30, 1888. In this he asked: "Is it possible to discover the cost and value of the carrier's property, franchises and equipment?" And while he was of opinion that such a task was a "prodigious," if not an impossible one, he thought that a trustworthy estimate of the relation existing between "the present worth of railroad property and its cost to those who are proprietors of it" might be obtained. He also thought that "the estimate of social agitators on the one hand and of men interested in the present status on the other might be far from the truth."

The idea present in the mind of Statistician, Senator and President is, and always has been, that the cost or capital of railways exercised a controlling influence on rates. In other words that the falsely alleged "exorbitant rates" on American railways were due to the necessity of paying interest and dividends on gross over-capitalization.

It has gone for naught with the "social agitators," back of this contention, that the rates on American railways are not exorbitant, being the lowest in the world. Neither have they been able to grasp the truth that rates are not fixed by dividends, because they close their understanding absolutely to the mute immutable testimony of such figures as the following, showing that while gross railway capitalization per mile has steadily increased' during the period of Mr. Adams' incumbency of his present office, the tendency of average rates has, almost invariably, been downward :

.Gross Capital and Average Receipts Per Mile, 1888-1906.

Year.

Gross Railway Capital per Mile.

Passenger Receipts per

Passenger Mile (Cents).

Freight

Receipts per

Ton Mile

(Cents).

1.001

.922

.941

.895

.898

.879

.860

1895 "

.839

.806

.798

.753

.724

.729

.750

.757

.763 .780

.766

.748

Here is an official demonstration that while the capitalization of American railways increased $11,438 per mile between 1888 and 1906 their average passenger receipts per mile declined more than a third of a cent, and their freight earnings per ton were less by over a quarter of a cent per mile.

President Roosevelt and Senator La Follette and Professor Adams and all intelligent students of railway affairs understand the significance of these figures, but the "social agitators" dwell upon the increase of capital and never tell their deluded followers that a reduction of one-third of a cent per passenger mile on the traffic of 1906 meant a saving- of $87,000,000 to the traveling - public, while a decline of 2.53 mills in the rate per ton mile meant a loss to the railways of $545,974,000 on the freight traffic of 1906.

These two items make a total greater by $138,000,000 than the aggregate of interest and net dividends paid by the railways in 1905. In other words the possible net profits of the railways in 1906 were practically cut in two by the decline in passenger and freight rates between 1888 and 1906.

Any relation between capitalization and rates such as is harped on by the "social agitators" is thus demonstrated to be an iridescent bubble proceeding from more "water" on the brain than there is in all the railways in the universe.

The prevalence of such popular hallucinations, however, emphasizes the necessity for an intelligent attempt on the part of the government to ascertain and publish to the world a reasonably trustworthy estimate of the cost and true valuation of the railways of the United States. The right to regulate carries with it the duty to protect. This was recognized in the passage of the original Act to Regulate Commerce and by the first Commissioners appointed under that act. In its first report written by the late Judge Thomas M. Cooley, than whom no higher authority ever wrote on railway subjects, the Commission says :

"The act to regulate commerce was not passed to injure any interests, but to conserve and protect. It had for its object to regulate a vast business according to the requirements of justice."

The power to decree reasonable rates carries with it the duty to preserve the property of the railways from confiscation or unreasonable rates, and the Supreme Court of the United States has declared that a railway company "is entitled to ask a fair return upon the value of that which it employs for the public convenience." Furthermore, it has decided that :

"In order to ascertain that value, the original cost of construction, the amount expended in permanent improvements, the amount and market value of its bonds and stock, the present as compared with the original cost of construction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case."

If it were established once for all, under the stamp of an impartial investigation, that the ascertained value of the railways after due consideration of these elements was equal to or exceeded the sum of their stocks and bonds, very much of the popular hostility to their management would disappear. Such hostility is undoubtedly fanned into radical demands for restrictive and oppressive legislation by the reiterated charges that extortionate rates are imposed in order to pay profits on excessive capitalization. Nothing short of a thorough governmental investigation of the cost and value of the property used for its convenience will satisfy the public who are right, the "social agitators" or the hundreds of thousands of American citizens who have invested billions in American railways.

Unless it can be shown, that the cost or present value of the railways approaches their capitalization, the crusade of the "social agitators" will continue to attract followers by confusing cries of "water" and "over-capitalization" in one breath and "exorbitant rates" and "discrimination" in another. This too in spite of the testimony of such an unprejudiced expert as Chairman Martin A. Knapp of the Interstate Commerce Commission, who as long ago as 1899 testified before the Industrial Commission as follows :

"I have not seen any instances in which the rates have seemed to much depend upon or be influenced by the capitalization of a road.

"Q. You have never seen such a case?

"A. I have not. The capitalization of the railroad, I think, cuts no figure in this rate question."

This from a firm believer in the principle that "a fair valuation on the railroad properties" is an essential basis for a judicial determination of what the proper rate should be, would seem to be conclusive.

It is therefore as a measure to protect their rights in any judicial investigation into their rates, that I would recommend to the railways that instead of opposing they should insist upon an official valuation of their properties. Such a valuation by an intelligent and fair-minded commission, would, in my opinion, result in a convincing demonstration that American railways; as a whole, are under-capitalized, and that all the "water" that from time to time has been present in their stocks has been absorbed by the cost of improvements, plowed back, as the farmers say, into them from operating expenses and net earnings.

Given such a Commission as that named by Governor La Follette himself, which has recently made a report on passenger rates in Wisconsin, remarkable for its comprehensive thoroughness and judicial fairness, and the railways have nothing to fear but much to gain by supporting Senator La Follette's proposition, so far as it relates to the valuation of their properties. If there ever was a case of a man smitten dumb by a granted prayer, it would be the Senator from Wisconsin by the report of any commission capable of making a reasonably adequate and just valuation of railway properties in the Lnited States.

The only thing the railways have to fear is the appointment of prejudiced or incapable appraisers."

It is the purpose of the present writer to anticipate, so far as may be, the findings of such an official body, concedingat the outset that anything like an authoritative valuation of railway property is beyond the reach of his expectancy. Even the government with all its resources and inquisitorial powers can never arrive at a definitive conclusion of what has been well called a "superhuman task."

The difficulties confronting such an undertaking are practically insuperable. That of numbering the stars deals with more tangible units. As the Railway and Warehouse Commission of Minnesota,, which has essayed the task for a single state, admits, it involves "the closest personal examination of all the physical properties of each company doing business in this state." Moreover those entrusted with it must be (to quote from the same authority) "Men of wide experience, who thoroughly understand the business in all its details, and who know the values of everything which enters mto the problem, from the right of way to the completed road, with all its necessary equipment. As every line has its own physical obstacles to overcome and the necessary conditions of efficiency and the necessary equipment in each case involves nearly every circumstance affecting the business, such work cannot be hurriedly or superficially done without complete sacrifice of the value and usefulness of the work as evidence."

Then the Commission enumerates a few of the items comprised in its investigation as follows :

"The detailed examination into the present value of lands for right of way, yards and terminals ; the cost of tracks, bridges, buildings, shops, machinery and tools, engine-houses and turntables, locomotives, freight and passenger cars, in fact, every item that enters into the physical property of the railroads of the state."

It must be evident that when the value of all these things have been estimated — they cannot possibly be ascertained — there remain the intangible rights and opportunities to be guessed.

What this may amount to can be "guessed" from the fact that the Tax Commission of Texas in 1906 valued the intangible properties of the railways of that state at $152,827,760 after deducting $188,600,939, the value of their physical property fixed by the Railroad Commission, "from the true cash value of all the property of said companies" in Texas.

No guess based on earnings can be admitted, being precluded by the purpose of the inquiry to find "a safe foundation upon which to construct fair and reasonable rates," for the rates are themselves the determining factor in the earnings.

Nothing short of omniscience can know or find out what the State of Minnesota has undertaken in the premises.

Manifestly, therefore, nothing absolutely conclusive will be attempted or should be expected in these pages. But it is believed that by applying various tests with candor and common sense a more or less convincing estimate of the present value of railway property in the United States, as a whole, may be arrived at. Statistics will be used only to aid ordinary intelligence to reach a sane conclusion.

To begin with, comparison will be invited to measure the cost and capitalization of American railways by that of foreign railways. This test involves a very simple process and would be of great assistance if the physical and financial conditions of railway construction and the necessities of traffic in different countries could be reduced to a common basis for comparisons. Unfortunately this is impossible and therefore comparison, "the right hand of logic," will only be appealed to to throw a sidelight on the subject.

Xext there is the historical method of investigation. This will trace the making of American railways from the small beginnings three-quarters of a century ago and their gradual evolution from the twenty-three miles of hcrse power railways in 1830 to the 317,083 miles of all kinds of track in 1906. Done with any approach to exhaustiveness this would require as many volumes as the "Messages and Papers of the Presidents," which will never be brought up to date. But no commensurate estimate of the cost and value of American railways can be made without at least a cursory review of the trackless task that confronted them, and the various stages of their development. "The Winning of the West" by the voyageur and pack train has no more stirring stories of courage, adventure and indomitable energy than can be found in the final conquest of this continent by the surveying parties, construction gangs and steam horses of railway history. And all along the trail of almost incredible achievement there has been one continuous chorus of pessimism and detraction. Criticism, and speculation between them have made the construction of American railways an undertaking beset with quicksands and whirlpools. The history of railway construction as written in Wall Street has been one thing; its history in the field, from the driving of the first spike by one of the signers of the Declaration of Independence, down to the present day, has been another.

Unfortunately, the financiering of railway companies has received more attention in public prints than the details of the expenditures involved in making the railways themselves. Coups in Wall Street by which the control over the properties was seized or shifted,, have obscured the unsensational progress by which those properties were steadily and often stealthily transformed from the "strap rail" period to vast transportation systems of today. And so we are left to guess what this transformation cost, and are forced to piece out any information we Jiave of original cost by an inquiry into what it would cost to produce existing railways at present prices. Thousands and millions of dollars have gone into the making of the railways of America which is represented in the properties but not in the capitalization of present companies. Panics, abandonments and reorganizations have dealt cruelly with the investments of thousands who put their faith in the alluring railway prospectuses of the past. The public has been the only invariable winner throughout the record of experiments, wrecks and receiverships that mark the financial history of American railways. It has been truly said that no matter how unprofitable any particular undertaking has been to its owners, no American railway has failed to bring profit, sometimes ten fold, to the community it served. This is true although there are thousands of miles of badly located roads in the union which never should have been built where they were first surveyed. Once built, however, the investment in them has been irrevocable, and the years come and go without bringing the balsam of dividends to cure the original mistake.

It is the futility of attempting to get at the original cost and subsequent sums poured into sustenance, as well as maintenance and improvement that has brought most economists to consider that the present value of railways can best be approximated by the cost of reproduction at present prices. The investment of foresight, energy and spirit of venture, to which we owe the railways as much as to the actual money invested, may be considered as being represented by the increase that has come in the value of the right of way and terminals, to which the railways have contributed their value. v

While it is doubtful if the present cost of reproduction new would cover the original cost of the railways, plus the cost of reconstruction concealed in yearly and daily maintenance and improvements to meet the ever increasing traffic, it is generally admitted that no other method would so nearly and justly recognize all the elements that underlie the present value of American railways. And after the cost of reproduction is estimated there remain other elements of value to be considered, notably that intangible, illusive thing known as franchise value. This is a possession of the railways which may have more value than their tangible property and yet there is no known method by which that value can be estimated with any approacli to convincing accuracy. It is more nearly represented in net earnings than anywhere else. The right to operate over a favorably located line in a territory of dense traffic between termini of increasing originating or distributing potentialities, is the possession that differentiates successful railways from the failures. The physical attributes are the mere means for its exploitation.

Such an inquiry as this must include an estimate of the commercial value of the railways as a system. This means the market estimate of the property, not according to its cost or its value as a physical proposition, but as based on its net income and what is termed the "strategic significance" of the property. In 1900 in response to a Senate resolution the Interstate Commerce Commission made one approximation and in 1905 Statistician Adams of the Commission made another appraisal for the Census Bureau. Both of these are interesting but unconvincing contributions to the study of the subject.

Another means of arriving at an estimate of the value of railways is to study them through the returns of the different assessors and state boards of equalization. Here they are weighed in scales which have never been tipped in the favor of the corporations to any notorious extent. When it is considered that they are regulated as public highways, the levying of any tax upon railways is an anomalous proceeding. But in the matter of taxation the railways are treated as private corporations and pay taxes in excess pro rata of those paid by the tillers of the soil, the manufacturers and the merchants whom they serve at the low r est rates on earth.

Through these various mediums, which in some instances overlap and afford cumulative testimony, it is thought an approach may be made to a convincing estimate of the present value of the railways of the United States — at least sufficiently convincing to dissipate from all reasonable minds the impression that as a whole American railways are grossly over-capitalized.

Nothing authoritative will be attempted in this inquiry, its only aim being to present facts that will enable the fair minded to arrive at a mean estimate of the value of our railways that shall approximate the truth. This, it is believed, will support the view of President Hadley of Yale that "the effect of a fair valuation would be overwhelming proof of the reasonableness of American railway rates as fixed at present."

A SEVEN BILLION DOLLAR ERROR

The Reductio Ad Absurdnm

In approaching a subject of such infinite possibilities for error, it is well at the outset to sweep aside the one obvious misstatement which from its bold reiteration may be regarded as the chief corner stone of the present agitation against American railways.

In his three-day speech before the Senate on April 19, 20, and 23, 1906, Senator La Follette having, on the estimates of one reckless writer, estimated that in 1903 there was seven billion dollars of water in the capital of American roads, took occasion to adopt the theories of another even less reliable author to astound his hearers with the statement that $8,000,- 000.000 odd of their capitalization in 1904 was entirely fictitious.

It is interesting to trace how Senator La Follete worked himself up to this magnificent absurdity. In 1893 Mr. Van Oss of London published a work entitled "American Railways as Investments," which, with true insular abandon, fairly reeked with charges of fraud, dishonesty and recklessness in the construction and financiering of American railways. As a result of Mr. Van Oss' alleged investigations, to quote Senator La Follette' s words, he arrived at "two important conclusions:

"First, that the average amount originally received in actual value for American railway bonds probably did not exceed 67 per cent;

"Second, that the original investor in American railway stocks certainly paid not more, on the average, than 10 per cent, of their face value, and probably less."

Then Senator La Follette, accepting these glaring fictions as facts, on his own account went on to construct lie following Eiffel tower of error:

"If an estimate of the actual investment on American railroads is computed on the basis of these final percentages given by Mr. Van Oss on the capitalization of 1904, as reported by the Interstate Commerce Commission, we get the following result :

Senator La Follette's Estimate.

Stocks, 10 per cent of $6,339,899,329, say

Total investment represented by $13,213,124,679, total capital.

"The remaining $8,000,000,000 odd are entirely fictitious capitalization, and cannot be considered in discussion of railway earnings."

Why Senator La Follette made the mistake of saying that $65,000,000 was a round figure for 10 per cent, of six billion odd, or did not swell his fictitious capitalization to eight and a half billion, as he well might by the showing of his original error, is not explained in the context in the Congressional Record.

That Senator La Follette was thoroughly possessed and fascinated by the false estimates cited in this speech is proved by the following extract from his speech of May 18, 1906, explaining his vote on the Hepburn bill :

"So long as the legislation relative to the common carriers of this country permits these corporations to increase their capital stock without limit, increase it without adding anything of value to their properties, and increase it solely with the purpose of fixing rates upon that inflated capitalization, in order to pay profits and dividends to those holding the stocks and bonds, in which they have no real investments, just so long this question will be a vital issue before the American people. There is today in the stock and bond valuation of the railroads of this country upward of seven billions of water."

Let us examine this fictitious Niagara in the light of incontrovertible facts :

According to the last statistical report of the Interstate Commerce Commission, the total railway capital outstanding, ineluding' stocks, bonds, income bonds, equipment trust obligations, and miscellaneous obligations was $14,570,421,478. Of this $2,257,175,799 stock and $641,305,030 bonds was owned by the railways in their corporate capacity and was not in the hands of the public, and in the language of the official statistician, "to the extent that such reductions are proper, overstates the capital." This leaves the net capital of the railways at $11,671,940,649.

There are certain physical appurtenances to the operation of railways which have a standard average value, namely, locomotives, cars, rails and ties. They cannot be bought for "water."

Their cost as they stood on June 30, 1906, may be tabulated thus :

Estimated Cost of Equipment, Rails and Ties.

Items. Cost.

Ties for ditto, 2,880 to the Mile, at 50 ct i 445,273,000

^Estimated.

This affords the basis for the following demonstration of the absurdity of Senator La Follette's claim that there is "upward of seven billions of water" in the stock and bond valuation of the railroads of this country today :

Demonstration of Senator La Follette's Error.

Cost of five items, as above

Balance

$7,401,074,049

7,000,000,000

Balance to represent the " upward "

Capital available for all other construction of 309,218 miles of track. . .

As it would cost more than $30,000,000 for spikes, irrespective of other fastenings, to attach the rails to the ties on

309,218 miles of track, and more than $625,000,000 for the ballast in which to imbed the ties, there can be no possible escape from the reductio ad absvirdum.

When one considers that the six items in the above table of cost merely represent the superstructure and ephemera of railways (and not all of these), which have to be continually renewed and replaced or they become defective or obsolete, amazement grows at the magnitude of Senator La Follette's error. Nowhere does the table include the real thing — the location, right of way, strategic position, grading, cuts, fills, bridges, tunneis, stations, freight houses, shops and other properties and rights that make the railway the highway upon which the traffic of a mighty people moves with ever-increasing volume and despatch. These constitute from two-thirds to three-fourths of the value of the property of the railways used for the service of the American public today. Unlike the items in the table, right of way and location of railways are not subject to depreciation, but increase in value with each passing year with the increase in population and wealth of the United States.

It is well for the Senator that the rule falsus in uno, falsus in omnibus does not apply to all senatorial utterances.

II Water In Railway Capital

Nothing has served so continuously to darken counsel in regard to American railways as the glib charge that they impose extortionate rates in order to pay dividends on watered stock. It flows with equal fluidity from the lips of economist, agitator and demagogue, and it has been thus flowing so long that it has been accepted as true by a majority of the American people. In truth, it has ever been mostly a theory, never a general condition.

Now, what is this "water" in railway capital which is the subject of such popular opprobrium?

Generally speaking it is used as a synonym for fictitious capitalization — meaning that either stock or bonds or both have been issued for which no equivalent was paid, or is represented, and that the value of the property is not equal to the face value of these obligations. In this obvious sense its use is noted in financial literature early in the seventies and it is first recognized by Webster in his 1879 Supplement as "Brokers' Cant."

In the Century Dictionary it is classed as "commercial slang," and is defined as follow r s :

"To increase the nominal capital of a corporation by the issue of new shares without a corresponding increase of actual capital. Justification for such a transaction is usually sought by claiming that the property and franchises have increased in value so that an increase of stock is necessary in order to fairly represent existing capital."

Legal writers define watered stock as a security issued as fully paid in, when, in fact, the whole amount of the par value thereof has not been paid in.

Under both of these definitions it will be perceived that there may be legitimate and illegitimate watering of railway capital. But the term has been so persistently and offensively abused by critics and commentators, as well as detractors of American railways, that the distinction is lost in popular discussions of the subject. The public has been led to believe that the increases in railway capitalization during the past thirty years have been largely fictitious ; that they have been made to conceal large dividends on stock, and to forestall the demands for a reduction in rates.

It matters little to the parties whose chief capital is denunciation of watered stocks that, water or no water, the increase in net railway capitalization from about $7,000,000,000 to $11,671,- 940,649 during the past twenty years has been accompanied by a reduction of freight rates from 1.04 cents to 7.48 mills per ton mile and of passenger rates from 2.19 cents to .0.002 per passenger mile. They will continue to cry "Water, water, everywhere !" in hopes that the discovery of a few cesspools in railway finance will convince the public that all sources of railway capitalization are polluted at the fountain head.

Senator La Follette is not the only advocate of a valuation of American railways who professes to think that they are floating islands surrounded by oceans of water. Only last winter the Washington correspondent of one of our great dailies wrote to his paper that :

"Every development of late shows that most of the big lines of railroads in the United States are vastly over-capitalized, some of them having a funded debt and capital stock issues amounting to from two to ten times their actual cost."

The point of this watery delusion was put thus : "It is easy to see that if a railroad has been capitalized at a figure five or ten times its value it must meet a fixed charge five or ten times as great as it should be expected to meet."

It will be observed that "actual cost" and "value" are here used as interchangeable terms and the illegitimate water in most of the big lines was said to be from 50 to 90 per cent.

To well-informed readers the mere extravagance of such a statement carries with it its own refutation. But to the suspicious, the prejudiced and the ignorant there is nothing incredible about the most palpable and self-stultifying exaggeration. If Senator La Follette could carry off a seven billion dollar misrepresentation without question in the United States Senate, why should anyone hesitate to believe a statement that for one part of cost there are nine parts of "water" in the capitalization of American railways?

Neither must it be thought that this cry of "water" is any modern invention ! In one form or another it has been a continuous chorus which has accompanied the floating of every railway enterprise since Colonel Stevens first sought to raise funds to construct a railway from the Delaware River to the Raritan in 1815. Every government or corporation issuing securities and selling them at a discount, whether at 90 per cent., as the German Empire has within six months, or at 50 cents on the dollar, as some of the early American railways had to, has watered its capital stock to that extent. In his letter of August 24, 1897, classifying the items to be charged to cost of construction, Statistician Adams recognized its legitimacy in these words: "To this account should be charged discount on securities sold; interest on loans affected, and on notes issued for construction purposes or overdue payments to contractors or other creditors, and discount, interest and exchange on other commercial paper issued for a similar purpose."