We, as retail investors, tend to extrapolate financial performance into the future. It’s a simple and useful technique of gauging normalized earnings power, provided it is done in the right scenario. However, there is one situation where simple extrapolation of profitability will yield very misleading results. That is when a company has high operating leverage.
What is operating leverage?
Operating leverage measures a company’s fixed costs as a percentage of its total costs. A company with a large proportion of fixed costs (high operating leverage) will earn a large profit on each addition unit of product sold. For such company, scale and volume are essential for profitability. Unsurprisingly, there are also companies with low operating leverage where variable costs are the majority of costs.
Examples of operating leverage
Imagine you are a fashion retailer who rents a shop space in an Orchard Road shopping mall. The bulk of your total …