“Give me a lever and a place to stand and I shall move the earth.” That’s what Archimedes said when describing the advantage that leverage gives. Force times distance on one side of the fulcrum equals force times distance on the other side. That’s how you can lift a hundred pound weight with only five pounds of push – if the distance on one side is twenty times that of the other. Of course, this only works if the lever and the fulcrum are stable and strong.
The same principle applies to financial leverage. A 1% return on assets can be multiplied to a 10% return on equity if the company is levered 10-to-1. That’s the way banks work, taking in deposits and making loans. They lend money at 4% and pay depositors 1%, pay their employees and other expenses, and the remainder – their net profit – is available to shareholders for dividends or buybacks or growth.
Of course, that leverage increases financial risk, as well as return. If a company is levered 10-to-1 and asset values decline by 11%, the company would become insolvent. The assets wouldn’t be worth enough, at those prices, to satisfy the liabilities. That’s what happened to a lot of banks during the housing bust, when home prices in some areas fell 40% or more – destroying their owners’ home equity, and wiping out the banks that held the mortgages. There’s no free lunch. Levered returns are higher, but riskier.
Finally, there’s operational leverage, where managers provide incentives and training to their staff to get more work done. If a manager invests 20 hours of her time in training, and gets a staff of 10 to improve productivity by 1%, management has just levered their own effort by 10 times. Managers can provide incentives as well that encourage their teams to improve the quality and quantity of their work. The right manager with the right structure and a well-trained and motivated team can work wonders. They literally change everything.
That’s what Steve Jobs accomplished at Apple, what Andy Grove did at Intel, what Jaime Dimon has done at JP Morgan. Archimedes was right: leverage – mechanical, financial, or operational – can move the world.
Douglas R. Tengdin, CFA