Indexing Operating Performance

Indexing operating performance is a method of performance measurement. Indexing operating performance compares internal financial performance (see financial statements) with the financial performance of other comparable companies (so called peers or peer companies). For the selection of peer companies the investor perspective is taken with regard to alternative investment opportunities with similar operative risks. The same perspective is taken when calculating the industry beta in the determination of the cost of capital.
Comparing performance to peers can be accomplished in two ways:
1. Operating Alpha: This is the difference between internal performance and the average or median of the peer performance (=Operating Index) for a financial metric (for example: EBIT Operating Alpha). Operating Alpha is the operating equivalent of the investment alpha, the out-performance return on an investment: It is an operating indicator or predictor based on financial metrics for the relative return on the market value of an investment.
2. Operating Rank: Indexing operating performance can also be expressed as the percentile rank performance of the company performance with respect to the peer performances. This method calculates the percentile rank of a financial metric. This percentile rank of a financial metric is called Operating Rank (for example Operating EBIT Rank). The indexing tools Operating Radar and Operating Contribution display several Operating Ranks to measure value gaps and value potentials in different companies or divisions independent of external effects such as economic cycles.
Difference to Benchmarking
Different from benchmarking, indexing operating performance uses an investor perspective to select peers for performance measurement. Classical benchmarking focuses only on peer companies with similar products or similar operating processes. Indexing uses an extended peer universe that includes companies that can be considered alternative investment opportunities from the perspective of an investor. This will include companies with similar distribution and purchasing processes which are subject to similar operating risks from an investor perspective. A similar perspective is used for calculating industry betas in deriving cost of capital.
The primary goal of benchmarking is product and process improvement . The primary goal of indexing operating performance is the measurement of value generation independently of external factors and universally comparable (e.g. standardized). Since indexing is primarily a trend analysis or a trend deviation analysis, the word "index" is used and not the word "benchmark".
Applications
Indexing operating performance has the following advantages over non-indexed performance measurement:
* elimination of external factors: If performance is measured relative to an external "Operating Index", external factors are eliminated because they affect all companies in the peer universe equally.
* standardization of financial metrics: If a financial metric is represented as a percentile rank compared to financial metrics of peer companies, then the value of that metric is standardized. The percentile rank has values between 0 and 100% which are universally comparable.
By today, there are two main applications of indexing operating performance:
* Indexed bonus targets are used to make bonus targets business cycle independent (see pay for performance). Indexed bonus targets move with the business cycle and are therefore fairer and valid for a longer period of time. An example of indexed incentive targets is the Bonus Index that is annually published by the Swiss finance research firm Obermatt for the German HDAX companies and the Swiss SMI and SPI companies.
* Indexed strategic controlling is used by finance, strategy and controlling executives in strategic and financial planning. It represents performance independent of external factors which enables the identification of misleading signals in performance measurement. Compare Operating Alpha, Operating Index, Operating Rank, Operating Radar, Operating Contribution.

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