Operating Leverage – A Framework For Anticipating Changes In Earnings by Michael Mauboussin
Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).
Visit his site at: michaelmauboussin.com/
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Michael Mauboussin: Operating Leverage
“Analysts’ usual optimism, their tendency to forecast in a narrow and comfortable range, and the business cycle prove to be the bane of their forecasts. Acceleration or deceleration in economic growth tends to catch analysts off-guard.” -- Vijay Kumar Chopra
- Analysts are commonly too optimistic about earnings growth and often miss estimates by a wide margin.
- This report outlines a systematic way to assess earnings revisions with a specific emphasis on operating leverage.
- We cover the drivers of sales growth and then discuss the value factors, which determine the impact of sales changes on operating profit.
- To measure operating leverage, we examine the relationship between the change in sales and the change in operating profit for the top 1,000 companies from 1950 through 2014. We also examine eight sectors.
- Operating leverage and financial leverage together determine earnings volatility.
- Sales growth, profit growth, and value creation do not always go together.
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.
Analysts are commonly too optimistic about earnings growth and often miss estimates by a wide margin. This is especially pronounced for companies that have high operating leverage and surprise the market with weak sales. Buy-side analysts are generally more optimistic and less accurate than sell-side analysts.
Operating leverage measures the change in operating profit as a function of the change in sales. Operating leverage is high when a company realizes a relatively large change in operating profit for every dollar of change in sales. Operating leverage is low when operating profit is mostly unchanged for every dollar of change in sales. Operating profit is earnings before interest and taxes (EBIT) and is the same as operating income. This report outlines a systematic way to assess earnings revisions with a specific emphasis on operating leverage. The goal is to be able to better anticipate revisions in expectations. The issue of operating leverage does not receive enough attention, in our view, and it can provide insight into excess returns. For instance, there is empirical evidence that operating leverage can help explain the value premium.
Exhibit 1 is the roadmap for this analysis. The process starts on the left side with an analysis of the change in sales. Sales changes, in turn, can be refined using “value factors” to determine the impact on operating profit. The value factors are based on established microeconomic principles. Consideration of sales changes and the role of the value factors allows you to calculate operating leverage, or “operating margin beta.” You can then incorporate the degree of financial leverage to determine the variability of earnings.
The main utility of exhibit 1 is to allow you to understand the cause and effect of changes in earnings. The interaction between sales and operating profit is crucial. Not all sales growth has the same effect on profitability. Note that you can use the roadmap to analyze the past as well as to anticipate the future.
The easiest way to think about operating leverage is as the ratio of fixed to variable costs. Fixed costs are costs that a company must bear irrespective of its sales level. If sales shrink, fixed costs don’t budge and profits fall sharply. Conversely, profits rise substantially if sales grow. Theme parks are an example of a business with high operating leverage. Roughly three-quarters of the costs for that business are fixed, with labor as the largest component.
Variable costs are linked to output. These costs rise and fall in tandem with sales. The commissions a company pays to its sales force is an example of a variable cost. Commissions move together with sales, limiting the degree of operating leverage.
Exhibit 2 illustrates the impact that sales changes have on operating profit margins for businesses with high (75 percent) or low (25 percent) fixed costs. The operating profit margin is 20 percent for both businesses when sales are $10 million. At $25 million of sales, the high-fixed-cost business sees its operating profit margin soar to nearly 60 percent, while the low-fixed-cost business has an operating profit margin of only slightly above 30 percent. At $5 million of sales, however, the business with high fixed costs loses money and records a margin of -40 percent, while the business with low variable costs breaks even.
Exhibit 3 shows the ratio of fixed assets to total assets by sector. A fixed asset is not sold or consumed during the normal course of business. Examples include land, manufacturing plants, and acquired intangibles. The basic idea is that companies that rely on a high ratio of fixed to total assets have high fixed costs. There is a positive correlation between the ratio of fixed assets to total assets and operating leverage.
It is important to underscore that all costs are variable in the long run. While the distinction between fixed and variable costs is practical and useful for modeling purposes, companies can reduce fixed and variable costs if sales decline. Further, growth eventually dilutes the advantage of an incumbent in a business with high fixed costs, because the ratio of fixed to variable costs declines as the industry grows.
Exhibit 4 shows the drivers of operating profit changes for the largest 1,000 global companies, by market capitalization, for the last 65 years. The sample excludes companies in the financial services and utility industries. Operating leverage is particularly pronounced in periods of recession and subsequent recovery.
The rest of this report has four parts. We start with the drivers of sales growth. We then discuss the value factors, which determine the impact of sales changes on operating profit. Next we review the empirical results of our analysis of operating margin beta, or how the change in operating profit relates to the change in sales. We conclude with data on financial leverage. Companies with debt incur interest expense, which serves to amplify the changes in operating earnings. Companies with high operating and financial leverage have greater swings in earnings, and hence risk, than those with low operating and financial leverage.
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