Measuring Operating Leverage
Posted: 1 May 2018 Last revised: 15 Feb 2020
Date Written: February 14, 2020
We examine a simple measure of operating leverage: the ratio of fixed costs (measured by depreciation and amortization plus selling, general, and administrative expenses) to the market (or book) value of assets. We find that this measure of operating leverage positively predicts returns and that its predictive power is stronger than previous measures of operating leverage. Operating leverage is not explained by common factors, distinct from the gross profitability effect, and is not explained by organization capital. The operating leverage factor helps explain the returns of book-to-market portfolios. Furthermore, a simple two-factor model with the operating leverage factor works at least as well as, but does not subsume, the Fama and French five-factor model.
Keywords: operating leverage, fixed costs; stock returns, factor models
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