operating leverage: what it is and how to look for it

operating leverage may be the key to stock selection

In my judgment, and given my growth-oriented way of looking at stocks, I think that operating leverage is the second-most important idea for potential investors in a company to understand.

(The first-most important concept is to make sure that the company is, and will remain, an economically viable entity–and that all shareholders will share in the profits the firm makes.  This isn’t usually a pressing issue for mid- and large-cap stocks in the US.  And it doesn’t take much time.  You can check out financial stability quickly in a service like Value Line–although you’re always better off looking at the financials yourself.  You have to be aware of the credit facts, in case that great start-up you own will likely run out of money before it can get a product to market.)

a key source of earnings surprise 

After you’ve put the issue of whether the company will survive behind you, the crucial issue for growth investors is the possibility of positive earnings surprise.  This means the chance that a firm’s profits will be growing faster than the market expects, for longer than the market expects.

That’s where operating leverage comes in.

what operating leverage is

Operating leverage is the idea that a company’s operating profits can rise and fall more rapidly than sales.  How can this happen?  I’ll go into detail in the next couple of posts, but the general concept is an easy one.

A company’s costs general fall into one of two categories:  variable or fixed.  Variable costs are those directly connected with the creation of the product or service sold.  Fixed costs are everything else.

In the world of manufacturing, where these distinctions were first made, variable costs are mainly the raw materials used in producing a product and the labor costs of the workers directly involved in making it.  Fixed costs are those that the company runs up whether it generates any output or not.

Fixed costs themselves are usually divided into two types:

–production related, like the salary of the plant manager, and the costs of building/leasing the factory and buying/renting the machinery in it; and

–SG&A, or Sales, General and Administrative.  These latter include the chairman’s compensation, as well as that of all others at corporate headquarters, plus the advertising/promotion budget and the cost of a salesforce.

variable vs. fixed–shades of gray

Yes, these are somewhat fuzzy concepts.  For instance, in return for a lower price, companies may have purchase contracts for raw materials that require them to pay for minimum deliveries, whether they take them or not.  Workers may also have employment contracts.  In neither case are expenses as “variable” as they might seem.  On the other hand, the firm’s salesforce and top management may be paid mostly in bonuses based mostly on sales/profit growth.  So these costs aren’t very “fixed.”

Still, such cases normally make only minor differences in a firm’s total results.

financial leverage is something else

Of course, there’s also another form of leverage a company may employ–financial leverage, which I’ve discussed in my recent post on return on capital vs. return on equity.

More tomorrow.