Value from a Different Perspective
If you have a conversation with the finance department or on Wall Street, you will hear different views of what value means. The definition of value from a finance person would include, of course, money. Within this book, we will begin to understand different perspectives on what value means and show how supply chain management and operations affect an organization’s financial performance. In the next chapter, we will discuss the monetary value of a firm in greater depth, but for now, taken together, firm value includes ROIC, growth rate, and cost of capital.4 It is incredibly beneficial for supply chain professionals to understand how these factors are affected by supply chain activities. In the end, you will not only know how operational metrics are affected by your decisions but you will also grasp how financial metrics are influenced by your decisions.
The connection between operations and finance is important. Only looking at a firm’s current operational performance does not indicate if it is making any profit at all or that it can remain in business. If we are merely looking at the firm’s financial performance, how do we know if it can sustain profitability into the future? We need to measure both financial and operational performance and connect the two to determine if we can generate value for the firm. We do this by looking at what drives value in the firm: ROIC, revenue growth, and cost of capital. Economic value is created whenever the ROIC exceeds the cost of capital (weighted average cost of capital [WACC]).
- Economic value created = ROIC × (ROIC – WACC)
PwC conducted a study in 2008 that connected supply chain and operations to financial performance using 600 companies that experienced supply chain disruptions. For these companies that experienced disruption, PwC found that shareholder value plunged when compared to their peers. In addition, their stock prices experienced greater volatility, and they suffered sharp declines in return on sales and return on assets. Even more, these effects in many cases lasted up to 2 years.5
On average, affected companies’ share prices (Figure 1.3) dropped 9% below the benchmark group during the day before and the day of the disruption announcement. Two-thirds of affected companies were lagging their peers in stock price performance a year after the disruption. The average stock return of those suffering from disruptions was almost 19 percentage points lower relative to the benchmark group over a 2-year period (i.e., 1 year before to 1 year after the disruption announcement date).
Figure 1.3 How supply chain disruptions affect stock prices. (From PricewaterhouseCoopers, From vulnerable to valuable: how integrity can transform a supply chain; Achieving operational excellence series, 2008.)
The investment community views disruption-experiencing companies unfavorably, and this uneasiness is likely to spread to employees, consumers, and suppliers. Compared to benchmark stocks, more than half of the affected companies experienced greater volatility for at least 2 years—a sign of diminished confidence among stakeholders. After controlling for normal market movements, the share price volatility (Figure 1.4) in the year after the disruption of affected firms was around 8 points higher than the benchmark. Two years after the disruption, the affected firms were under performing the benchmark by an even higher 10 points.
Figure 1.4 How supply chain disruptions affect share price volatility. (From PricewaterhouseCoopers, From vulnerable to valuable: how integrity can transform a supply chain; Achieving operational excellence series, 2008.)
Disruptions take a significant toll on profitability as reported by standard accounting measures. More than 60% of affected firms experienced lower returns on assets and sales. After controlling for normal industry and economic effects, the average return on assets (Figure 1.5) for disruption-experiencing firms was found to be down by 5 points.
Figure 1.5 How supply chain disruptions affect return on assets. (From PricewaterhouseCoopers, From vulnerable to valuable: how integrity can transform a supply chain; Achieving operational excellence series, 2008.)
Return on sales (Figure 1.6) suffered an average drop of 4 points for companies that experienced disruptions. On both measures, the returns of benchmark companies were stable over the 2-year period while those of disrupted companies fell significantly.
Figure 1.6 How supply chain disruptions affect return on sales. (From PricewaterhouseCoopers, From vulnerable to valuable: how integrity can transform a supply chain; Achieving operational excellence series, 2008.)