To conceptualise this imagine a lever whereby sales are on one side, and operating income is on the other side. A company with high operating leverage is one whereby small changes in sales will have big impacts on their operating income. This works both ways – small improvements in sales produce big improvements on operating income, and small declines in sales will produce big declines in operating income. On the other hand, a company with low operating leverage is one where changes in sales (up or down) will have small impacts on operating income.
Let’s look at two general scenarios to see how each group – high operating leverage, and low operating leverage – would fare.
Declining Sales:
- Big Operating Leverage = the declines in sales will produce large declines in operating income.
- Small Operating Leverage = the declines in sales will produce small declines in operating income.
Improving Sales:
- Big Operating Leverage – the gains in sales will produce large gains in operating income.
- Small Operating Leverage – the gains in sales will produce small gains in operating income.
So you can see here that big operating leverage companies will have big swings in their operating income (and thus, their FCF) as their sales change, whilst small operating leverage companies will have small changes in their operating income as their sales change. This is why some stocks fall hard in a downturn (airlines, cruises) whilst others don’t fall as much.
So how do we know whether a company has big or small operating leverage? We can just google search the industry and you will find sources that tell you whether the industry has big or small operating leverage. Alternatively, you can calculate it. The formula is:
Operating Leverage = (Change in Sales)/(Change in Operating Income)
So you calculate the change in sales between say 2018 and 2019, and calculate the change in operating income between 2018 and 2019, and divide them. To get more data points, do this for every year that you can (2008 and 2009, 2009 and 2010, etc). To get a more long-term view of things, as results can be skewed in a singular year, use the formula for years that are wider apart (say 2010 and 2015, 2011 and 2016, etc).
So overall, many investors would say that the big operating leverage companies are risky whilst small operating leverage companies are less risky – the potential downside for the former is high whilst the downside for the latter is low. This doesn’t mean to avoid the big operating leverage companies altogether, it just means that you need to invest in them only when they are doing well, and avoid them when they are struggling. This means that you need to know when the industry is booming and when it is busting. Also, since an industry can bust at any time, you need to be paying close attention for any signs of it faltering. So it’s somewhat dependent on your timing , something a lot of investors hate because it’s quite dependent on luck.