Question

The Pacheco Company is analyzing a possible investment in constructing a new facility in the suburbs, comparing its costs and efficiencies to Pacheco’s current site. What other alternatives might it consider?

Why might your company choose to take actions to lower its operating leverage?

Answer 1

What Is Investment Analysis?

Investment analysis is a broad term for many different methods of evaluating investments, industry sectors, and economic trends. It can include charting past returns to predict future performance, selecting the type of investment that best suits an investor's needs, or evaluating individual securities such as stocks and bonds to determine their risks, yield potential, or price movements.Investment analysis is key to a sound portfolio management strategy.

Understanding Investment Analysis

The aim of investment analysis is to determine how an investment is likely to perform and how suitable it is for a particular investor. Key factors in investment analysis include the appropriate entry price, the expected time horizon for holding an investment, and the role the investment will play in the portfolio as a whole.

In conducting an investment analysis of a mutual fund, for example, an investor looks at how the fund performed over time compared to its benchmark and to its main competitors. Peer fund comparison includes investigating the differences in performance, expense ratios, management stability, sector weighting, investment style, and asset allocation.

In investing, one size does not fit all. Just as there are many different types of investors with unique goals, time horizons, and incomes, there are investment opportunities that match those individual parameters.

Strategic Thinking

Investment analysis can also involve evaluating an overall investment strategy in terms of the thought process that went into making it, the person's needs and financial situation at the time, how the portfolio performed, and whether it's time for a correction or adjustment.

Investors who are not comfortable doing investment analysis on their own can seek advice from an investment advisor or another financial professional.

Types of Investment Analysis

While there are countless ways to analyze securities, sectors, and markets, investment analysis can be divided into several basic approaches.

Top-Down vs. Bottom-Up

When making investment decisions, investors can use a bottom-up investment analysis approach or a top-down approach.

Bottom-up investment analysis entails analyzing individual stocks for their merits, such as their valuation, management competence, pricing power, and other unique characteristics.

Bottom-up investment analysis does not focus on economic cycles or market cycles. Instead, it aims to find the best companies and stocks regardless of the overarching trends. In essence, bottom-up investing takes a microeconomic approach to investing rather than a macroeconomic or global approach.

The global approach is a hallmark of top-down investment analysis. It starts with an analysis of economic, market, and industry trends before zeroing in on the investments that will benefit from those trends.

Top-Down and Bottom-Up Examples

In a top-down approach, an investor might evaluate various sectors and conclude that financials will likely perform better than industrials. As a result, the investor decides the investment portfolio will be overweight financials and underweight industrials. Then it's time to find the best stocks in the financial sector.

In contrast, the bottom-up investor may have found that an industrial company made for a compelling investment and allocated a significant amount of capital to it even though the outlook for the broader industry was relatively negative. The investor has concluded that the stock will outperform its industry.

Fundamental vs. Technical Analysis

Other investment analysis methods include fundamental analysis and technical analysis.

The fundamental analyst stresses the financial health of companies as well as the broader economic outlook. Practitioners of fundamental analysis seek stocks they believe the market has mispriced. That is, they are trading at a price lower than is warranted by their intrinsic value.

Often using bottom-up analysis, these investors will evaluate a company's financial soundness, future business prospects, and dividend potential to determine whether it will make a satisfactory investment. Proponents of this style include Warren Buffett and his mentor, Benjamin Graham.

Technical Analysis

The technical analyst evaluates patterns of stock prices and statistical parameters, using computer-calculated charts and graphs. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical analysts focus on patterns of price movements, trading signals, and various other analytical charting tools to evaluate a security's strength or weakness.

Day traders make frequent use of technical analysis in devising their strategies and timing their buying and selling activity.

Real-World Example of Investment Analysis

Research analysts frequently release investment analysis reports on individual securities, asset classes, and market sectors, with a recommendation to buy, sell, or hold them.

For example, on Feb. 20, 2020, Charles Schwab issued an analysis of consumer staples equities. The report takes a macroeconomic approach, looking at various positive and negative political and economic developments that could influence the sector. It looks at retailer cost-cutting efforts on the upside and the potential impact of ongoing trade disputes on the downside. It suggests that prices in the sector have already been driven up substantially by investors seeking the safe haven that this sector has always represented.

The analysts then assigned an overall neutral assessment rating of "market perform." This neutral rating means the consumer staples sector should provide returns in line with that of the S&P 500.

What Is Operating Leverage?

Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.

The higher the degree of operating leverage, the greater the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

What Does Operating Leverage Tell You?

The operating leverage formula is used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit. The formula can reveal how well a company is using its fixed-cost items, such as its warehouse and machinery and equipment, to generate profits. The more profit a company can squeeze out of the same amount of fixed assets, the higher its operating leverage.

One conclusion companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to the selling price, contribution margin or the number of units they sell.

High and Low Operating Leverage

It is important to compare operating leverage between companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly defined.

Most of a company’s costs are fixed costs that recur each month, such as rent, regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered and profits are earned.

Other company costs are variable costs that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials used to make products. Some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs.

For example, a software business has greater fixed costs in developers’ salaries and lower variable costs in software sales. As such, the business has high operating leverage. In contrast, a computer consulting firm charges its clients hourly and doesn't need expensive office space because its consultants work in clients' offices. This results in variable consultant wages and low fixed operating costs. The business thus has low operating leverage.