There are two types of leverage in investing – operating and financial leverage. We have discussed financial leverage to a great extent in previous articles, hence we shall not touch on this but rather focus our efforts on explaining operating leverage using a investment case study: Netflix.
What is Operating Leverage?
The thing that differentiates it from financial leverage, would be operating leverage has a larger percentage of fixed expenses. High operating leverage means most costs are fixed. Companies with high operating leverage would essentially mean that a 1% increase in revenue would lead to a greater than 1%, say 5% increase in net earnings. This is because they do not have to increase costs proportionately to generate a 1% increase in revenues.
However, with any form of leverage, while on the upside it magnifies profits, it too will magnify losses on the downside. Hence, any small error in forecasting sales revenue growth can result in a magnified error in earnings projections. Hence, this is why companies with high operating leverages are much more difficult to value.
At the end of last week, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. The chat spanned many different topics, Read More
Identifying High Operating Leverage Companies
- Companies that require a large pool of labour
- Companies that require to invest in a lot of inventory
- Companies that has a high capital expenditure model
- Companies with high material and production costs
Degree of Operating Leverage
While two companies may have high operating leverage, they may vary in the degree of extent. To calculate the degree of operating leverage of a company would be by dividing the percentage change in operating income by the percentage change in sale revenues. To put this into perspective, we shall use two examples of companies with high operating leverage – Netflix and Choice Hotels.
For FY2014, Netflix reported an increase in revenues of 25.8% resulting in operating income increasing by 98.5%. Whereas, for Choice Hotels, they reported an increase in revenues of 4.6% resulting in operating income increased by 9.7%. Hence, two companies with high operating leverage can vary in terms of the degree of extent.
Case Study: Netflix
The thing with most technology companies like Netflix is that they have very high operating leverage. Initially, they require large amounts of money to be invested into the company for the production of the platform and perhaps server space as well. However, the variable cost is kept to the minimum as these companies are able to scale up very easily to cater to an increasing number of consumers without having to really incur any variable cost.
This is the reason why we see such huge growth rates for such technology firms where analysts are constantly able to keep increasing the target price of the company. However, lets take a step back and analyse it rationally. Operating leverage is a two-edged sword. While it may result in high growth rates for the company, it can result in a company being vulnerable on two fronts.
- If the company faces any risk of a decrease in sale revenues, it would result in an amplified effect on earnings resulting in a huge discrepancy between the market price and the intrinsic value of the company valued based on earnings.
- Coupled with financial leverage, it can result in disastrous outcomes.
A company that has both high operating and financial leverage can go bankrupt very easily. This is because with small declines in sale revenues, it would resulted in a magnified decline in earnings resulting in the company being unable to meet its high interest payments. The irony with debt capital markets is that it is available when one least needs it not available when one needs it the most.
One has to be aware of the different forms of leverage as it does not only manifest in the form of financial leverage but as operating leverage as well, which is something not that commonly understood. While a high operating leverage has its benefits, one has to invest in such companies with great caution. Not understanding it completely can result in disastrous outcomes and in some cases a permanent loss of capital.