“For a fundamental investor, anticipating revisions in expectations is the key to generating attractive returns. Sources of those revisions include fundamental outcomes (typically earnings revisions) and an assessment of how the market will value those fundamentals (multiple expansion or contraction). Investors who are able to forecast earnings in a year’s time that are substantially different than today’s expectations can earn meaningful excess returns.”

Michael Mauboussin

Operating leverage is one of the more important considerations when analyzing a company, but it is one of the more underutilized ideas. The better operating leverage a company owns, the quicker the company can scale up as it grows, the lower the leverage; the opposite is the case.

Another benefit to studying operating leverage is seeing management efficiency in action: better management in controlling costs, and focusing on efficiencies across the board which will lead to better results.

Keep in mind that each industry will have different degrees of operating leverage. For example, comparing the operating leverage of Apple to GM is not a fair comparison, but comparing Apple to Microsoft is a more reasonable comparison. Context matters, and it is important to keep that idea in mind.

In today’s post, we will learn:

Okay, let’s dive in and learn more about operating leverage.

What is Operating Leverage?

Operating leverage, according to Investopedia, is:

“Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.”

Thinking simply, a company’s operating leverage translates revenue growth into operating income, or EBIT (earnings before interest and taxes). And that leverage also translates into the volatility of the operating income or operations of the company.

Schematic

Description automatically generated with low confidence

Companies with higher operating leverage carry higher fixed costs regardless of whether they do $1 of sales or millions. Low-operating leverage companies may have higher variable fixed costs but lower fixed costs.

The biggest idea to understand is operating leverage measures any changes in operating profit related to changes in revenues. As revenues scale-up, operating leverage should increase profitability. If a company’s sales grow but its operating income grows at the same pace, its operating leverage is low, and vice-versa.

For example, if a company sells $10 and its operating margin is 50%, its operating profit is $5. But if the company’s sales grow to $20 and the operating margin remains the same, then the company’s profits will scale correspondingly to $10. However, if the company has operating leverage and the operating margin falls to 40%, then the company’s operating profit would grow to $12.

Below is a table we will explore further on the post.

The graph above highlights some of the changes necessary to produce operating leverage, which we will explore in a moment.

The biggest drivers of operating leverage are costs, whether fixed or variable, compared to the revenue. The fixed costs and variable costs equal the total costs a company expends to operate the business. It includes raw materials, inventory, payroll, R&D, marketing, administration, compensation expenses, and commissions.

Other costs included are non-cash items such as depreciation and amortization and stock-based compensation, which the company uses to reduce earnings, even though actual cash doesn’t flow out for those expenses.

The company’s fixed costs are costs they have to pay regardless of sales, such as rent, insurance, and taxes. And when sales fall, these fixed costs don’t move, causing bigger drops in profits. On the flip side, if sales rise, profits also rise. A great example of this is an amusement park like Six Flags which has high operating leverage. With over 75% fixed costs and labor occupying the highest cost, when the parks were shuttered during Covid they lost huge, but the parks will see growing profitability as they reopen.

Variable costs such as commissions flex as revenues rise; commission expenses rise in tandem. The commissions of a company limit the degree of operating leverage they can bring to bear to improve profitability.

Keep in mind that different sectors have higher fixed costs than others. For example, sectors such as energy, materials, and telecommunications carry high fixed costs because of the nature of their businesses. Where information technology, consumer staples, and consumer discretionary carry much lower fixed costs.

It is important to understand that all costs are variable in the long run; separating between fixed and variable is a good practice and great to understand. But when companies experience downturns, such as March 2020, many will have the ability to reduce both fixed and variable costs in response.

Why is Operating Leverage Good?

The best way to explain why operating leverage is good for businesses is to use an example. My favorite example to explain operating leverage is Microsoft.

The majority of Microsoft’s upfront costs, such as research/development and marketing, are fixed costs. Whether Microsoft sells one copy of Microsoft Office or ten million, the company’s costs remain unchanged. So, once Microsoft sells enough copies of Office to cover its upfront costs, every dollar afterward drops to the earnings or bottom line.

Microsoft or Apple is a perfect example of a high leverage operating business.

A retailer such as Amazon’s retail segment is the perfect example of a company with low operating leverage. Amazon’s retail segment has a rather low fixed cost level, while the variable costs the segment carries are quite high. Merchandise inventory is Amazon’s retail segment is the highest cost. Each time a customer orders something from Prime, Amazon has to pay for the supply of that product. Because of that, Amazon’s cost of goods sold continues to grow as sales grow.

When analyzing any company, we need to assess the degree of operating leverage the company carries and what impact the rise or fall of revenues will have on profitability.

The degree of operating leverage corresponds with a company’s cost structure, and that cost structure is critical to the company’s profitability.

For example, if a company with high fixed costs such as a utility experiences short-term revenue changes, they will struggle because those fixed costs will occur regardless. That increases risk in the event of a fall in sales or makes the company far more volatile.

In contrast, a company with a low degree of operating leverage will experience less volatility when revenues change. Companies with higher degrees of operating leverage, like Microsoft, will experience larger changes in profits during revenue changes.

Operating leverage can inform investors about the volatility of the company they are analyzing. For example, companies with high operating leverage can be great, profitable companies; they are also vulnerable to big changes in business cycles.

In good times, high operating leverage companies can supercharge earnings. Still, companies with costs tied up in machinery, plants, real estate, and networks can’t easily move on a dime and cut expenses.

Bottom line, operating leverage is not a panacea; it is only part of the equation of analyzing a company.

How Do I Determine Operating Leverage?

Getting to the good stuff now, let’s go back to our diagram from above and dissect how to calculate operating leverage.

Before looking at a formula, let’s explore some of the drivers of operating leverage.

Sales Growth

Sales growth is far and away the biggest driver of operating leverage and growth of a company. To estimate sales growth, we have a few approaches we can use.

The first idea is matching the economic growth of the economy the company resides. For example, as a base rate, most companies in the U.S. will grow at least at the rate of the economy or GDP, which historically ranges between three to four percent.

Of course, some sectors will be more sensitive than others, with consumer discretionary and industrials highly correlated to GDP, while consumer staples and health care are far less correlated.

The second idea, industry growth, is the first resource most analysts choose when making any sales predictions. The first thing we must consider is where the life cycle of the industry resides. For example, physical retail stores are in the decline phase of the cycle with the rise of internet retail. Industry growth tends to follow an S-curve, with accelerating sales early in the cycle before flattening out. Still, again each industry will have different life cycles and different growth rates.

The biggest mistake is forecasting high growth rates when the company or industry is in the middle of the life cycle. Michael Mauboussin gives a great example of color TVs in the 50s and 60s. As the TVs gained more following, the producers added more capacity and accelerated capacity at the top of the S-curve, even as sales flattened.

Changes in market share also impact sales forecasts. Emerging markets tend to be the most volatile, but they start to flatten out as they mature. A great example is the cell phone industry; early on, there were great sales and competition, but as saturation started to occur, the great growth that companies such as Verizon enjoyed flattened out.

As I mentioned earlier, sales growth is one of the fundamental drivers of value for any company. Still, it is important to realize that sales growth, profit growth, and value creation are not related.

Companies only create value when their operating profit exceeds its cost of capital; if those levels match or fall below, it is either destroying or not adding value.

Volume Factors

Next, let’s look at the four drivers of value for a company.

Operating Margins

Operating margins tell investors how efficiently the company creates profits from the operations of the business. The higher the number, the more efficiently the company operates.

Each industry or sector will have operating margins respective to their particular sector. For example, the operating margins of Costco don’t compare to Visa as they are completely different types of business.

We measure operating leverage by comparing changes in sales with changes in operating margins. By comparing companies in the same sector, we can see if our particular company should expect margins to expand or contract as it matures.

Operating margins are the basis of determining the profitability of companies. The numerator in NOPAT (net operating profit at taxes) that we use to calculate ROIC (return on invested capital) tells us how efficiently the company reinvests its assets to grow revenues.

Financial Leverage

The capital structure of a company goes a long way towards determining the operating leverage of the company. For example, a company with a high debt load also has a high interest expense on the income statement. That interest expense decreases the company’s net income and can be thought of as a fixed cost.

That financial leverage magnifies changes in operating income. Consider the below chart as an example:

Operating Profit

Interest Expense

Pretax Profit

Company A

$150

$0

$150

Company B

$150

$30

$120

The higher interest expense creates more volatility in earnings and different values for the company. Debt is a necessary ingredient in a growing business, but the debt load must be in relation to its sales volume. Bigger debt loads lead to higher interest expenses which decrease the operating profits.

Michael Mauboussin offers a fantastic checklist to consider when considering the operating leverage of any company you are analyzing:

How to Calculate Operating Leverage?

The formula to calculate operating leverage is:

The best way to illustrate the formula, let’s use a company’s financials to look at the operating leverage. We will use Microsoft as our guinea pig and their latest annual report dated July 30, 2020.

Now, pulling the numbers from the income statement and then determining the change by subtracting the current year from the previous year, and likewise with the revenues; and then divide it by the previous year’s numbers and then divide all of that to arrive at our degree of operating leverage.

Below is a chart giving us the change in operating income and revenues.

2020

2019

Change

Operating Income

$52,959

$42,959

$10,000

Revenues

$143,015

$125,843

$17,172

Now we can calculate the operating leverage, which is:

Operating leverage = ($10,000/$42,959) / ($17,172/$125,843)

Operating leverage = 0.23 / 0.14 = 1.64x

It is a fairly easy formula to calculate once you know what to look for, and to learn more about how this formula works, click the link below:

The degree of leverage helps us determine how exposed the company is to changes in sales. And a great practice is to look at the operating leverage over longer periods, say five to ten years, and compare Microsoft to others in its industry to get a sense of the company’s position.

Investor Takeaway

Operating margins are the key to a successful company because if the company isn’t producing operating profits at some point in its life cycle, then survival is not an option. Young companies struggle to get costs under control as they focus on growing quickly to gain market share and stay alive. Once they achieve maturity and sales level off, the operating efficiency becomes more important.

Measuring operating leverage is an important focus of analysts to determine future profitability as the company grows, and determine the variability if the economy turns sour. It helps analysts and investors measure the volatility in earnings and any risk associated with the company.

To learn more about this important subject, check out the two resources which were instrumental to my continuing learning on this subject:

And with that, we will wrap up our discussion on operating leverage.

As always, thank you for taking the time to read today’s post, and I hope you find some value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave