Value Creation & Operations: The Investor View

Operations forensics

Investors and analysts often need to look into a firm's operations more deeply than traditional financial statements and models allow. Operations forensics investigates a firm’s operations to establish factual impact on its value. Operations forensic can be broken down into the following components: operational indicators, operations details that can predict future performance; operational due diligence, methods for verifying companies' claims about operational excellence and valuing their operational assets; and operational turnaround, an innovative approach to buyout and turnaround strategies. 

Quantifying value

Economic Value Added (EVA)

Economic Value added is an estimate of the economic value created by the firm. Specifically, EVA measures the value created in excess of the required return of the company’s investors. Weighted Average of Capital (WACC) is the weighted rate that the company is expected to pay on average to its debt and equity holders.

EVA = (ROIC - WACC) x Invested Capital

Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) captures the two types of financial impacts of operational improvements: return (operating profit or income generated per period) and required invested capital.

ROIC = Operating profit per period / Invested capital in the operation

ROIC = Operating Profit / Sales x Sales / Capital

ROIC = Profit Margin x Capital Returns

ROIC should only include profit from operations and assets used in operations. ROIC often paints a clearer picture of the value created through operations than ROA and ROE.

Return on Assets (ROA)

ROA = Net income per period / Total Assets

Return on Equity (ROE)

ROE = Net income per period / Shareholder Equity

RANKING OPERATIONAL KPIs

Firms monitor metrics that are traditionally considered crucial, that are monitored by their competitors or that tend to change continuously. A performance indicator is important if it is a leading indicator of overall firm performance. We rank operational KPIs through sensitivity analysis of the the financial metric. So the value sensitivity to a certain KPI equals the percentage change in value when the KPI is increased by 1% or more generally:

Value sensitivity to a KPI = Percentage change in value / Percentage change in the KPI

Finally rank the variables by their sensitivities; the variable with highest sensitivity is the most important performance indicator.

Linking METRICS to Operations

To visualise the link of ROIC to operational KPIs, we can use a ROIC map.

In order to expand the boxes further in the ROIC tree, sometimes a process flow diagram is useful to show and understand interrelationships between various operational metrics.