An additional analysis on operating leverage estimation methods

Abstract

Purpose – This paper aims to identify the more accurate method of estimating a firm’s degree of operating leverage (DOL) between two popular DOL estimation techniques: that proposed by Mandelker and Rhee (M&R), and that proposed by O’Brien and Vanderheiden (O&V). Design/methodology/approach – O’Brien and Vanderheiden argue that M&R measure growth in operating earnings relative to the growth in sales rather than DOL. The authors estimate the relative growth estimate, RGE, from the O&V technique (operating earnings growth rate/sales growth rate) and compare this with the DOL estimates from the M&R technique to see if they are similar. Findings – The authors find that the DOL estimates from the M&R method are indistinguishable from the relative growth estimates from the O&V method, providing the first direct evidence that O&V’s critique is correct. The M&R DOL estimates primarily measure the growth in operating earnings relative to the growth in sales, not DOL. Originality/value – A firm’s DOL is a determinant of its common stock’s systematic risk, which determines a firm’s equity cost of capital. The equity cost of capital is a fundamental part of capital budgeting, capital structure and stock price analysis. Accurately estimating a firm’s DOL is important to researchers and corporate financial managers. Existing diversity in DOL estimation techniques raises questions about the validity of various techniques and limits comparability of existing studies. This paper demonstrates why the O&V technique should be used in place of the M&R method.