Applications of Indexed Operating Performance
Indexed Operating Performance reported as Operating Alpha is a true measure of operating performance independent of external factors, and also a standardized metric enabling comparisons in like terms. These two new capabilities are made possible by indexing, and they yield concrete advantages for Value Based management with applications for incentive compensation systems, strategic planning, and investment decisions.
Each key performance indicator (KPI), financial ratio or performance metric represents three variables: the value driver being measured, the company it is being measured for, and the time period in which it is being measured. Normally it is not possible to directly compare different KPIs, as it would be like comparing "apples and oranges." But standardizing performance measurements as percentile ranks through indexing allows any two of these three variables to be held constant while isolating and varying the third for comparison, now "apples to apples."
For example, normally it is problematic to compare performance on the same value driver, say profit margin, of the same company for even two consecutive but different years. Company managers operate under different external economic conditions from one year to the next. Prices change. So comparing profit margins year to year may measure those external conditions more than actual operating performance. It would be comparing apples to oranges. But by expressing each year's profit margins in relative terms as a percentile rank within the industry index, they can now be compared apples to apples: managers achieved a higher or lower percentile rank performance from one year to the next, while operating under the same conditions as their peers in both periods. Their performance alone was measured, not the economy's or industry's performance. Their Operating Alpha was measured.
In the example above the time period was varied, with the other two variables held constant. If the time period is held constant along with the company, the metric variable can be isolated for comparison in a similar fashion. For example, normally it is difficult to compare different metrics, even for the same company in the same year, because they are not like terms: how do a certain number of turns of net working capital compare to a certain number of percentage points of sales growth? By indexing, we can express each not as turns or percentage points, but both as percentile ranks among their peers. The difference in their ranks is the difference in Operating Alpha created by each.
Finally, even the company variable can be isolated. Companies in different regions and industries achieve different operating performance and cannot normally be compared directly. But a direct comparison is made possible by indexing the performance of each within its own industry and market conditions, and comparing only the percentile rank, or Operating Alpha, of each company, now apples to apples.