Operating Leverage and Risk Premium

Abstract

We demonstrate that the operating leverage effect induced by fixed costs is affected by variable costs in firm production. This motivates us to propose two measures of firm-level operating leverage: a theoretically driven measure from a production-based model, and a measure from machine learning estimation. Both measures outperform the operating leverage measures in the existing literature in capturing the elasticity of operating profits with respect to gross profits. Furthermore, the operating leverage and risk premium relation depends on firms’ gross profitability. For more profitable firms, fixed cost induces higher risk premium, consistent with the conventional wisdom on the operating leverage effect. For sufficiently low gross profitability firms, however, the operating hedge from variable costs creates a negative relation between operating leverage and risk premium. Our result poses a challenge for the explanation of the value premium relying on operating leverage.