An additional analysis on operating leverage estimation methods

Steven Stelk, Sang Hyun Park and Michael T Dugan

Journal of Financial Economic Policy, 2015, vol. 7, issue 2, 180-188

Abstract: Purpose - – This paper aims to identify the more accurate method of estimating a firm’s degree of operating leverage (DOL) between two popularDOLestimation 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 thanDOL. The authors estimate the relative growth estimate, RGE, from the O&V technique (operating earnings growth rate/sales growth rate) and compare this with theDOLestimates from the M&R technique to see if they are similar. Findings - – The authors find that theDOLestimates 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&RDOLestimates primarily measure the growth in operating earnings relative to the growth in sales, notDOL. Originality/value - – A firm’sDOLis 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’sDOLis important to researchers and corporate financial managers. Existing diversity inDOLestimation 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.

Keywords: Estimation; Financial risk and risk management; Corporate finance and governance; Capital budgeting (search for similar items in EconPapers)
Date: 2015
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Persistent link: https://EconPapers.repec.org/RePEc:eme:jfeppp:v:7:y:2015:i:2:p:180-188

DOI: 10.1108/JFEP-10-2014-0056

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