How does operating leverage affect stock returns?

In investing, there are two types of risks that any investor must always be aware of, the business risk and the market risk.

The business risk pertains to the uncertainty that a company may not be able to generate enough revenue to cover its expenses, while market risk relates to the possibility that the company may incur losses as a result of economic performance. By nature, market risk is inherent to the system, which investors cannot completely avoid, while business risk is unique with the company, which investors can control and minimize through diversification. During this time of crisis, with the market risk of an economic recession happening almost inevitable, it is a given that many listed companies in the Philippine Stock Exchange (PSE) are expected to report substantial decline in their earnings, if not losses this year.

Such impact on earnings may not be necessarily the same for all because every company has different business risk. Some companies may be able to manage their losses and recover quickly while others may stay badly damaged for some time. One of the factors that affect the business risk of a company is the amount of fixed costs it has. When a company has large fixed costs relative to its total costs, it means it has a high breakeven point that it needs to surpass to make a profit.

But once the company has covered its fixed costs and become profitable, any slight increase in its revenue can cause a large effect on its operating profits.

While this may be lucrative during good times, this may also be destructive during bad times because any decline in sales can also amplify the losses. The degree to which a company combines its fixed costs and variable costs is what we call the operating leverage.

When the degree of operating leverage (DOL) of a company is high, it simply means its operating profits are more volatile. The higher the DOL, the more sensitive its operating profits are to changes in sales.

Because of this, the business risks that come from a higher DOL may always lead to lower share price valuation.

If we look at the DOLs of listed companies at the PSE, we can find that stocks with market size of at least P100 billion tend to have lower EV/Ebit valuations as their DOLs increase in 49 percent of the time. This means that a large-cap stock with a high DOL is most likely to trade at a discount in terms of EV/Ebit multiple compared to a similar stock with lower DOL.

We recall that the EV/Ebit ratio, which stands for enterprise value to earnings before interests and taxes, is like the price-to-earnings ratio only that it focuses on operating profits instead of net profits.

While there is strong correlation for large-cap stocks, there seems to be a weak negative correlation for stocks with market size below P100 billion.

For example, for stocks with market cap of P10 billion and above, the correlation is only 7 percent, while for stocks with market size below P10 billion, the correlation is practically nothing at less than 1 percent.

If we will follow historical correlations, we can say that during this period of economic contraction, the large-cap stocks will be the most vulnerable to suffer significant losses in market value.

Last year, the median DOL of the PSE index was 0.19 and its corresponding EV/Ebit valuation was at 10.2 times, but today, after the recent release of 2019 financial results, the median DOL has increased to 0.65 and the market EV/Ebit is lower at 8.4 times.

With a higher DOL and expected reduction in revenues this year, does this mean that the PSE index, which is composed mostly of large-cap stocks, will continue to fall?

In a difficult environment like this, where market and business risks are rising, the DOL can be a useful tool in identifying the right stocks to invest by looking at their cost structure. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 83rd batch of RFP program live online this June 2020. To register, email [email protected] or text at 0917-9689774.