Properties of time‐series estimates of degree of leverage measures

Abstract

Empirical studies suggest that time-series regression estimates of the degrees of operating and financial leverage have a tendency to produce measures less than one. According to ex ante theory, these measures should be greater than one for firms operating above the breakeven point. There have also been suggestions that the biases in these estimates may be attributable to an underlying increase in unit sales. This work presents evidence that these counter-intuitive measures are produced by changes in the firm's operating parameters (unit price, variable cost, fixed cost and interest payments). It further suggests that attempts to control for the underlying change in unit sales substantially increase the volatility of predicted estimates.

Can Operating Leverage Be the Cause of the Value Premium?

“…The point‐to‐point approach estimates DOL as a ratio of changes in earnings to changes in sales, or fixed assets to total assets (Ferri and Jones, 1979; Lord, 1998). The time‐series regression estimates seem to be more appropriate theoretically (Dugan and Shriver, 1989), although both approaches suffer from similar biases (Lord, 1998). 5 As we discuss below, we use a time‐series regression approach as our main empirical method but also use a point‐to‐point approach as a robustness check.…”

“…The difficulty in classifying externally reported costs into fixed and variable components leads to the common definition of DOL as an elasticity measure of EBIT given a change in unit demand. However, many firms do not report data on unit output (or manufacture multiple products), so it is common to use sales rather than output (Lord, 1998). 5 According to theory, DOL estimates should be higher than one if the firm is operating above breakeven point and could be negative if the firm is operating below breakeven.…”

An additional analysis of estimation techniques for the degree of financial leverage

“…The elasticity-based measures of DFL from M&R and O&V are superior to static accounting measures, but tradeoffs exist between the two estimation techniques. Lord (1998) and O&V techniques tend to produce DFL estimates less than one, which is not a logically possible value for a firm operating above break-even. Lord argues that measures of DOL and DFL using time-series regression tend to produce estimates less than one for firms operating above breakeven because of changes in the firms' operating parameters.…”

“…The elasticity‐based measures of DFL from M&R and O&V are superior to static accounting measures, but tradeoffs exist between the two estimation techniques. Lord () examines the M&R and O&V techniques. Citing results from M&R (), O&V (), Dugan and Shriver (), and Dugan et al.…”

Diversification, Fee Income, and Credit Union Risk

“…Following Mandelker and Rhee (1984), O'Brien and Vanderheiden (1987), Dugan and Shriver (1992) and Lord (1998), DeYoung and Roland use a two-stage time series regression approach to obtain an estimate of each bank's earnings sensitivity to changes in revenue. In the first stage each credit union's quarterly total revenue and earnings is de-trended and de-seasonalised by regressing the profit and revenue series on a (cubic) time trend, T, and the first, second and third quarter dummy variables, Q1, Q2 and Q3:…”