Operating Alpha


Definition

Operating Alpha is the difference between the actual value of a company's financial metric and the Operating Index of that metric of the respective Peer Universe.

Description

We call our new indexed measure of operating performance Operating Alpha, because it measures the outperformance of operating managers the same way investment alpha, or Jensen's Alpha, measures the outperformance of portfolio managers compared to an index.

It is fitting that the product of indexed operating performance, Operating Alpha, be linked to the investment world by its name. Indexed operating performance is the next step in Value Based management, and the purpose of VBM is managing companies from the investor perspective. By indexing operating performance not just from the product peer perspective, but also from the investor perspective of operating peers in the capital markets, companies are better equipped to create their own Operating Alpha, thereby creating investment alpha for their shareholders as well.

Since an investor perspective is taken when defining the Peer Universe, the Operating Alpha is an indicator of Investment Alpha (for instance the Jensen-Alpha), thus the difference between the shareholder's returns of the company and the average investment return of the reference benchmark.

Best projections of investment alpha are expected from Operating Alpha of the Economic Value Added (EVA Alpha) or from Operating Alpha of Net Income (Net Income Alpha) since in valuation theory these metrics ultimately drive enterprise value.

Good results are also expected from Sales Growth Operating Alpha, EBIT Margin Operating Alpha and Invested Capital Turns Operating Alpha since the respective market multiples (Sales Multiple, EBIT Multiple, Price-to-Book Ratio) are of key importance for empiric company valuation.




Application

The Operating Alpha of a financial metric is free of interpretation fallacies unlike the absolute value of the metric. A positive Alpha trend is always good, a negative Alpha trend always poor. This is not the case with absolute metrics. A positive absolute value development is not necessarily good, as in the case where the Operating Index increases by even more.

As shown in the graph above, such fallacies can happen easily. Viewed from the internal perspective, margins are highest in 2003 and 2007. Viewed against the market, however, the margin is worst in 2007. Internally viewed, the margin is lowest in 2005. Against the market, the margin performance is the best (the highest against the Operating Index or almost at the 3rd quartile or 75th percentile, respectively). It is also apparent that the performance in 2004 was just as good as in 2003 although the margin contracted from 6.3% to 5.4%. The reason is the contraction of the Operating Index by a similar difference. In Obermatt's experience, such false conclusions arise in about four out of five internal KPI comparisons. Obermatt supports its clients to avoid such fallacies in their performance measuring.

Examples

To exemplify the development of a typical Operating Alpha, we cite the Swiss luxury goods company Richemont (PDF download). Hermann J. Stern's article in the German Corporate Governance magazine comments on the application of Operating Alpha for Executive Management and the Board (German: PDF download). On the Social Science Research Network, there is a white paper on how Operating Alpha is used in bonus systems (Download PDF). In "Finanz und Wirtschaft" Raiffeisen Bank Group is quoted as an example of indexed bonus targets based on Operating Alpha for Swiss Banks (downlaod PDF).

Ask for your customized peer universe to calculate your Operating Alpha at Obermatt. Your first set of Operating Alpha calculations is free of charges. (Contact).

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