How does operating leverage affect equity returns?

When investing, there are two types of risks that every investor should always be aware of, commercial risk and market risk.

Business risk relates to the uncertainty that a business might not be able to generate enough income to cover its expenses, while market risk relates to the possibility that the business will incur losses due to its economic performance. By nature, market risk is inherent in the system, which investors cannot completely avoid, while business risk is unique to the company, which investors can control and minimize through diversification. In this time of crisis, with the market risk of an economic recession almost inevitable, it stands to reason that many companies listed on the Philippine Stock Exchange (PSE) are expected to report substantial declines in profits, if not losses this year. .

Such impact on profits may not necessarily be the same for everyone, as every business has different business risks. Some businesses may be able to manage their losses and recover quickly while others may remain badly damaged for some time. One of the factors that affect a company’s business risk is the amount of fixed costs it has. When a business has large fixed costs relative to its total costs, it means that it has a high break-even point that it must exceed in order to make a profit.

But once the business has covered its fixed costs and has become profitable, any small increase in revenue can have a big effect on its operating results.

While it can be lucrative in good times, it can also be destructive in bad times, as any decline in sales can magnify losses as well. The degree to which a business combines its fixed costs and its variable costs is what we call operating leverage.

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

For this reason, the business risks that arise from a higher DOL can always lead to a lower valuation of the share price.

If we look at the DOLs of companies listed on the PSE, we can see that stocks with a market size of at least 100 billion pesos tend to have lower EV / Ebit valuations, as their DOLs increase by 49%. time. This means that a large cap stock with a high DOL is most likely to trade for a lower price in terms of EV / Ebit multiple compared to a similar stock with a lower DOL.

We recall that the EV / Ebit ratio, which represents the value of the company in relation to earnings before interest and taxes, is like the price / earnings ratio only in that it focuses on operating earnings rather than on the bottom line.

While there is a strong correlation for large cap stocks, there appears to be a weak negative correlation for stocks with a market size of less than 100 billion pesos.

For example, for stocks with a market capitalization of 10 billion pesos and above, the correlation is only 7%, while for stocks with a market size of less than 10 billion pesos, the correlation n ‘is practically zero at less than 1%.

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

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

With a higher DOL and expected earnings reduction this year, does that mean that the PSE Index, which is made up mostly of large cap stocks, will continue to decline?

In a challenging environment like this, where market and business risks increase, the DOL can be a useful tool in identifying the right stocks to invest by examining their cost structure. INQ

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

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