Leverage: Small is Mighty!

Attention, wordsmiths! Two days ago, Peggy Noonan – former White House speechwriter to Presidents Ronald Reagan and the senior George Bush, coiner of the phrase a kinder, gentler nation – anointed our recent economic expansion The Age of Abundance.

A nice turn of the phrase, isn’t it? Her columns “pegs” (no pun intended) the length of the era at 25 years. According to Ms. Noonan, it began with Steve Jobs’ launch of the Apple Macintosh in 1984 and ended … unfortunately for us all … right around now.

So what is Peggy’s prescription for our economic malady? In true conservative Republican fashion, she exhorts the small business start-ups in the private sector to focus on innovation and return our nation to prosperity. In fact, in the final paragraph of her column, she observes that no one trusts big anymore.

But Peggy, many of us in the entrepreneurial realm never trusted “big” to produce large returns on our investments. Our reason for dis-trusting “big” is embedded in simple arithmetic.

A Simple Example

Let’s consider a simple example. Let’s assume that TinyCo and BigCorp are competitors in the catering business. They charge each customer $3,000 per event and spend $2,000 per event to deliver their services. And they keep a close eye on their indirect costs, each maintaining a meager budget of $5,000 for administrative expenses.

Let’s assume that the only difference between TinyCo and BigCorp is the number of customers served by each firm. TinyCo is new to the industry and only serves 6 customers per month. BigCorp launched its business a year before TinyCo entered the market, and thus has now grown to 9 customers per month.

Which firm will produce greater earnings growth in the short term? Which will attract more investor dollars?

You might think “Well … they’re exactly the same, except that BigCorp is bigger. They have more customers. They own 60% of the market. And they are more efficient because, although bigger, they have learned to ‘make do’ with the same $5,000 administrative budget. So, of course, BigCorp should attract more investor dollars.”

That would be a very logical response … but it is most likely an incorrect one! To see why that is the case, let’s work up a simple arithmetic chart:

Let’s assume that a new customer comes to town and needs a caterer; naturally, TinyCo and BigCorp both compete for their business. If TinyCo wins the contract, its customer base will grow from 6 to 7, and its net profits will quite literally double from $1,000 to $2,000. But if BigCorp wins the contract, its customer base will grow from 9 to 10, and its net profits will only increase by 25% from $4,000 to $5,000. If you are a short term investor, and if you believe that TinyCo and BigCorp each have an equal 50/50 chance of snaring the new customer contract, which firm would you recommend for investment purposes?

The answer to that question is quite obvious, isn’t it? If share prices increase whenever expectations of future earnings increase, then you would undoubtedly prefer to invest in the firm (i.e. TinyCo) that has a 50% chance of doubling its earnings. Why would any one ever choose the firm (i.e. BigCorp) that can only offer a 50% chance of a far smaller percentage gain?

The Role of Financial Leverage

Chartered Financial Analysts – the stock market gurus who crunch these numbers for a living – call this phenomenon leverage. Because it so fundamental to their work, they are tested on their knowledge of various leverage formulas within the Business Risk Ratios section of Level 1 of their CFA Exams.

Why do they need ratios to explain what we can see on our profits chart? Well, a good ratio can often capture an entire chart’s worth of information in a single data item. Look at the two green lines of numbers in our chart, for instance. TinyCo might say that its leverage statistic is $6,000 divided by $1,000 or 6.00. And BigCorp might report that its leverage statistic is $9,000 divided by $4,000 or 2.25.

Why are these numbers so useful to a CFA? Well, if TinyCo’s CFO tells his analysts that he hopes to increase his revenue base soon by 16.67% (i.e. from $18,000 to $21,000), the CFA can simply crunch a few numbers on the back of an envelope and discover that 16.67% times 6.0 equals 100%. In other words, the CFA doesn’t need any profit data to conclude “My goodness, net earnings might increase by 100%! They might double!”

However, if BigCorp’s CFO tells his analysts that revenue might increase by only 11.11% (i.e. from $27,000 to $30,000), the CFA might conclude, “11.11% times 2.25 equals 25%. Well, now, a 25% increase in net earnings is not bad … but it sure ain’t 100%!” Once again, no profit data would be required to draw these conclusions.

To be sure, there are certain periods of time when large companies do out-perform their small rivals. Nevertheless, the small-firm effect is one that has been known for many, many years … and we at Enterprise Man are delighted to thank Peggy Noonan for popularizing it with her readers!