understanding the power of operating leverage in investing
In the complex world of the stock market, understanding key financial concepts will make your life easy. Once you start focusing on important mental models, you will be able to identify winners with more ease and precision. One such concept that holds significant importance is "Operating Leverage." In this blog, we'll understand what operating leverage is, explore its relevance in businesses, its impact on future financials, and determine how companies increase fixed assets strategically.
Operating leverage is a financial metric that gauges the sensitivity of a company's operating income (or profit) to changes in revenue. In simpler terms, it examines how a change in sales affects a company's operating profits. Companies with high operating leverage experience more significant swings in profits with changes in sales, while those with low operating leverage see more stable profit margins. Wondering how this happens? We have explained this in detail below.
Operating leverage can be calculated as:
Operating Leverage= Percentage change in operating income / Percentage change in sales
Understanding the operating leverage of a company is vital for fundamental investors in the stock market. It provides insights into how efficiently a company can transform its sales into profits. A high operating leverage ratio suggests that a company can potentially enjoy higher profits when sales increase, but it also means greater risk when sales decline.
If operating leverage plays out positively for a business then that business will see a wild expansion in profits. In the stock market, this can lead to rerating of the business and this can generate massive wealth for investors.
One way companies increase their operating leverage is by investing in fixed assets. Fixed assets, such as machinery, equipment, or property, form the backbone of a company's operations. When a company strategically increases its fixed assets, it aims to enhance production capabilities, efficiency, and overall business performance.
This increase in fixed assets leads to a decline in profits temporarily. Let’s understand this in detail. If a company buys a machine worth Rs. 10 Cr. then from that moment, they have to show the depreciation cost for those fixed assets. Even though the asset is not in full (or partial) use, profitability takes a temporary hit due to increased depreciation.
So, you need to dig deep to find out companies sitting on the operating leverage. Analyzing profitability ratios alone will not give you a clear picture. The real magic happens when that asset is used. And how does this impact the financials? Continue reading to find out!
The decision to increase fixed assets can have a lasting impact on a company's future financials. Let's break it down with a simple example:
Again, let’s consider a manufacturing company that invests in a new production line. This increased fixed asset allows the company to produce more units without significantly increasing variable costs (we already talked about depreciation). If demand for the product rises, the company can meet it efficiently, leading to higher sales and, consequently, higher profits.
However, in times of low demand, the fixed costs still need to be covered, potentially impacting profit margins.
Imagine Company A and Company B, both in the same industry. Company A has higher operating leverage due to increased fixed assets, while Company B has a lower fixed asset base.
So, if you can identify companies sitting on operating leverage and expecting tailwinds, half of your job will be done there. Then you just need to allocate the right amount to create huge wealth.
With sharpely, you can easily identify companies with high operating leverage. Wondering how? Let’s build a screen to filter these companies.
As we analyzed, companies with high operating leverage have a non-linear relation between their sales and profit. For these companies, profits increase at a faster rate compared to their sales. Based on that we can define rules for the screener.
Rules:
Based on these simple rules, here is a list of companies.
Here is the backtesting performance of the strategy we created using the above rules.
As you can see, our strategy has generated a whopping 32.39% CAGR compared to the 13.67% CAGR of Nifty 50. Do remember that, this is not a buy or sell recommendation. This is just an example of how you can use sharpely to identify good companies with confidence.
For fundamental investors in listed companies, operating leverage is a very important mental model. By evaluating a company's operating leverage, investors can gain valuable insights into its ability to navigate varying market conditions, especially when it comes to managing high demand. This understanding becomes a key element in making informed investment decisions, ultimately contributing to a robust and well-informed investment strategy. Using sharpely you can easily screen these companies and create fully automated investment strategies!
