This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The question: "What is the right basis of capitalization?" is almost identical with the question: "What is the best measure of wealth?" To this latter question there are three possible answers. The most obvious is that wealth is measured by the cost of the property which is owned, plus whatever surplus value has been accumulated. Thus, if a farm cost $10,000 and has been improved to the extent of $500 a year, it should, in the course of two years, be worth $11,000. But, supposing that before the end of the two years some one in the neighborhood struck oil? The property would immediately acquire a value which would have very little reference to the original investment in the accumulation of betterments. Unexpected factors wholly outside the control of the owner of property are continually modifying its value so that it is quite out of the question for anyone to depend wholly on records of his investments and of accumulations as a method of measuring his wealth.
The second method is to measure wealth by the cost of reproducing property. If a man has a factory which has been running for 20 years, he may be ready to grant that his records of investments and accumulations would be of little use in determining its value but he might suggest that the present cost of building another plant of the same quality and size would be a correct measure of its value. This may be accepted as satisfactory so far as strictly tangible assets are concerned. But to every piece of property there attaches a certain intangible value. A man running a successful retail shop would not be willing to part with it, ordinarily, in exchange for another shop which was just as well fitted up and carried the same stock but which had been unsuccessful. A street railway company that was running smoothly and in harmony with the public sentiment of its territory would not accept in exchange for its track and rolling stock the exactly similar assets of some other company which had incurred public ill-will. It is possible - at least theoretically - to reproduce physical assets, but it is impossible to reproduce goodwill, organization, prestige, and the like. Hence, the attempt to measure wealth by figuring the cost of reproducing properties breaks down as soon as we begin to measure the value of intangible assets.
The third method is the capitalization of earning power. One man owns a piece of real estate, which brings him a clear net income under a long-term lease, of say $50,000 a year; another man owns a piece of property for which he paid just as much but which yields only $10,000 a year. Assuming that these two incomes are equally stable, can there be a question in anyone's mind that the first property is worth five times as much as the second? Note the assumption that the two incomes are equally stable. The likelihood of continuance of earning power and the ease with which it may be transferred are, of course, important factors to be considered. To what extent they should be allowed for, and in what way the value of any given property is to be determined on the basis of its earning power, are questions to be discussed a little farther on in this chapter. It is enough here to point out that earning power is the chief result of tangible and of intangible assets. If we take into account not merely current earnings but also potential earnings, then we have here a measure of wealth which must be a true and satisfactory measure. After all, in buying property for business reasons, what do we buy? Not merely so much real estate or so many articles. We are buying income. In the same way a man's individual wealth is shown, not by what he has invested - which may have been chiefly wasted - but by what he is getting out of his investments. If the answer that earning power is the best measure of wealth is granted, and if the proposition that "capitalization" of an enterprise is an approximate estimate of its wealth is accepted, then it would seem to follow that the correct basis of "capitalization" is earning power. This answer, however simple and sound it may appear to us, is not a principle of the law governing corporations which, on the contrary, assumes that investment is the only correct basis of capitalization. Out of this conflict between legal theory and business practice grow many difficulties and evasions.