We, as retail investors, tend to extrapolate financial performance into the future. It’s a simple and useful technique of gauging normalized earnings power, provided it is done in the right scenario. However, there is one situation where simple extrapolation of profitability will yield very misleading results. That is when a company has high operating leverage.

#### What is operating leverage?

Operating leverage measures a company’s fixed costs as a percentage of its total costs. A company with a large proportion of fixed costs (high operating leverage) will earn a large profit on each addition unit of product sold. For such company, scale and volume are essential for profitability. Unsurprisingly, there are also companies with low operating leverage where variable costs are the majority of costs.

#### Examples of operating leverage

Imagine you are a fashion retailer who rents a shop space in an Orchard Road shopping mall. The bulk of your total cost is going to come from your rent. The rent does not change depending how many shirts you sell. The first few shirts you sell will be used to cover the rental. For these, you earn zero profits. But after that threshold, all the shirts that you sell subsequently are going to be almost entirely profits.  EBIT and net margins are only going to increase past that point.

Compare this to a scenario where you are a lone consultant. You bill your clients on an hourly basis. Your costs are mainly variable as it is basically the opportunity cost of receiving wage. In this scenario, you earn a fixed amount of profit for each hour of work, no matter how long you are working.

#### How do you calculate operating leverage?

[drizzle]There is no single metric to represent operating leverage. Investors can get a sense of the degree of operating leverage by observing incremental margins over time.

To calculate incremental margins, divide the % change in EBIT by the % change in sales. A business with high operating leverage should exhibit increasing incremental margins overtime, assuming that revenue growth is positive.

For example, the Alaskan Barrel Company (ABC) has the following financial results:

Revenues                                       \$100,000

Variable expenses                           \$30,000

Fixed expenses                               \$60,000

Net operating income                   \$10,000

Variable expenses are 30% of sales. ABC’s sales then increased by 20%, resulting in the following financial results:

Revenues                                     \$120,000

Variable expenses                         \$36,000

Fixed expenses                             \$60,000

Net operating income                    \$24,000

Net operating income more than doubled, despite sales increasing by only 20%

#### Investment Implications

Companies with high degree of operating leverage do not lend well to extrapolation as profits often grow much faster than sales do. The opportunity exists if you are able to identify a company with high operating leverage at a price of a company with low operating leverage.

At the same time, high operating leverage is a double-edged sword. A small percentage decline in sales will result in a dramatic decrease in profits. For this reason, it is easy to observe that cyclical industries such as steel or shipping tend to have high operating leverage. Technology companies also have high operating leverage. That is why they are valued on hefty price to sales multiples despite being loss-making. However, such companies require more frequent monitoring due to their sensitivity to sales.

The next time you do extrapolation, pause and consider first if the business under analysis has high operating leverage.

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