when i was a new investor i focused exclusively on the p/e ratio when i was analyzing stocks.
That single decision caused me to pass on buying some of the greatest growth stocks of the last 20
years. Only later did i learn about a key business attribute that makes the p/e ratio all but useless
when analyzing some stocks. Importantly once i fully embrace this business concept,
i now know when i should use the p/e ratio and when i should ignore it so what are we
talking about we'll discuss that next my name is brian ferraldi and my name is brian stoffel
thanks to quarter for sponsoring today's video brian what is this key attribute that i'm talking
about the attribute that we're talking about today is operating leverage the simplest way
to understand operating leverage is this it's when a small increase in sales can lead to an
outsized increase in profit brian that might sound like magic but the good news is it's just math and
we can show how this principle works by looking at the income statement now operating leverage
affects most parts of the income statement but we're going to focus specifically on the top
half of the income statement there are two things to understand the first is the cost of goods sold
that's just how much it costs to make a product the second are operating expenses that's another
way of saying what it costs to run your business if you want to learn more about these two costs
check out our deep dive into the income statement so when a company's revenue is growing its fixed
costs are staying the same that allows its margins to enhance which means that its profits
can grow at an even faster rate than revenue over time which is a wonderful factor for investors all
right brian to showcase these principles in action let's go back to our favorite small business cafe
soleil all right so using our farmer's market coffee stand as an example let's take a look
at how we could have some operating leverage now the first thing that we're going to tackle is the
cost of goods sold what it costs to make a cup of coffee and let's use an example let's say that we
sell a thousand cups of coffee all right to sell a thousand cups of coffee there's a lot of
inputs and it's not just the beans they're important but there's the cream the sugar
the cups themselves and when you add it up it comes to a dollar per cup it costs us to
produce so if you sold a thousand cups of coffee and you charged three dollars per cup that would
give you revenue of three thousand dollars taking our dollar per cup cost into consideration that
would cost you a thousand dollars so your gross profit three thousand minus one thousand equals
two thousand dollars and if you divide gross profit by revenue that gives you a gross margin of
sixty seven percent which is pretty good so that is pretty good but let's amp it up to
five thousand cups now if you commit to selling 5 000 cups of coffee you will have a lot more
buying power with your suppliers so that will give you the ability to negotiate even lower prices on
many of those inputs this is technically called economies of scale but is a key factor that allows
companies to increase their profits faster than revenue that's right and while we would never do
that because we get the coffee beans from a family that we live on the farm with let's just say we
did it across the board and we got a 10 discount on all of them then all of a sudden if you add
together all the inputs it takes to make a cup of coffee we go from it costing a full dollar to just
90 cents now that might or might not seem like a big difference but let's do the math so you're
still selling those five thousand cups of coffee for three dollars each which gives you fifteen
thousand dollars in revenue however because you negotiated a ten percent discount on your cost
of goods sold five thousand times ninety cents is just four thousand five hundred dollars so because
of your increased buying power from going from 1 000 cups to 5 000 cups you were able to lower your
cost of goods sold slightly and that increased your gross margin by 3 okay so we talked about
ways that we can get some leverage from the cost of goods sold but let's investigate operating
expenses because that's where the real leverage comes in as we talked about in our deep dive into
the income statement cafe soleil has some fixed operating costs such as insurance permits and
coffee roaster depreciation now even though you don't pay any of your employees because you're all
owners of the business you still have about a thousand dollars in operating expenses that you
must pay for each and every year so let's go back to our first example where we sold a thousand cups
and we didn't have any leverage in the cost of goods sold we had two thousand dollars in gross
profit but you gotta throw that thousand dollars in fixed operating expenses in there which means
that our operating income comes out to one thousand dollars divide that one thousand by
revenue of three thousand and you have operating margin of thirty three percent that's a really
good operating margin its own right but let's scale it up to those five thousand cups of
coffee to see what happens as a reminder your operating expenses are fixed so they don't change
depending on how many cups of coffee you sold so we just have to subtract one thousand dollars for
operating costs if we subtract that from the much higher gross profit of ten thousand five hundred
that gives up an operating income of nine thousand five hundred dollars which is an operating margin
of 63 percent much much higher than your old operating margin all right to really drive this
point home we can look at the numbers our sales increased 5x but because of operating leverage
and economies of scale our profits increased much faster nine and a half times that's operating
level and you can see how powerful this principle can be for investors and businesses well brian
that was a useful example but let's use a slightly more complicated company to see how this works in
the real world with tesla yeah what tesla has done to its financials over the last 10 years showcases
operating leverage principle beautifully before we did that we wanted to give a shout out to this
video's sponsor which is quarter quarter's mission is to make every interaction between companies
and their investors meaningful corda does so by providing frictionless access to conference calls
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store of your choice and search for quarter that's q-u-a-r-t-r thanks quarter for sponsoring today's
video and for making an awesome product that i love using so if we rewind the clock to 2012 tesla
did 413 million dollars in sales that year it cost the company 383 million dollars to produce that
revenue that gave it a gross profit of 30 million dollars which is a 7 gross margin that's not that
strong but let's fast forward to the trailing 12 months as of this recording the company recorded
revenue of 47 billion dollars now because of economies of scale the cost of goods sold
was 36 billion dollars which is much more than in 2012 but less as a percentage of revenue that
leaves us with gross profit of 11 billion dollars we divide that buy our revenue and we see that
our gross margin has increased substantially to 23 just on the cost of goods sales alone the company
more than doubled its gross margin which is a huge increase for investors but we're not done yet
let's go and add in the operating expenses now automakers have huge fixed costs it just takes a
certain amount of money to operate a factory to produce cars because of that tesla's operating
expenses were much higher than its gross profit for that reason the company was actually burning
394 million dollars on an operating basis which is an operating margin of negative 95 percent
in 2012. however if we fast forward to today we can see that operating expenses have increased
markedly since 2012 but they are less as a percentage of the gross profit today there
are six billion dollars which leaves a positive 5 billion dollars in operating income over the past
12 months and that gives you an operating margin of 11 a lot better than negative 95. so between
2012 and 2021 tesla took advantage of economies of scale and operating leverage which helps its
operating income swing from a huge loss to a huge gain one way of visualizing where the company was
at different stages is that back in 2012 it was roughly here when it comes to operating
leverage but today tesla is in a very different state they've passed the break-even point and
it's more likely that it is here in this stage of development well brian valuation is tricky
in general but it can really get tripped up an investor if you start to use the price to earnings
ratio before operating leverage and economies of scale have kicked in if you're lacking at a
company in this stage of its growth using the p eu ratio will often give you a false signal that the
company is way too overvalued to see why let's take a look back at amazon's operating results
during its remarkable run as a public company these two charts show amazon's revenue and net
income from when it came public through 2016. this is before operating leverage had kicked in you can
see that revenue growth was very stable and very steady however you can see that the company's net
income was very erratic sometimes the company was slightly profitable sometimes it actually produced
a net loss that's because the company wasn't yet focused on profitability for that reason
if you focused on the company's price to earnings ratio during this time period you would be
confused sometimes it would be a very high number that was in the multiple hundreds sometimes the
number would be negative and yet throughout this whole period it was a great decision to buy amazon
stock the p e ratio was very confusing because amazon was in this phase of its development
in fact it was going back and forth between stage 2 and stage 3 depending on how much money it was
spending for that reason the price to earnings ratio was essentially useless now let's show how
the company has done over the last six years the company's revenue growth has continued to move
higher however amazon has finally started to focus on profitability and as you can see the company's
profits have exploded higher that's operating leverage kicking in so amazon shifted from being
at this phase of the growth development to this phase that means we're getting closer to that
price to earnings ratio being useful and we can see that if we look at what has happened to this
company's p e ratio over the last five years while it's still high in absolute terms it has come down
down down even though amazon's price has gone up up up that's because economies of scale and
operating average were really kicking in which allowed amazon's profits to grow much faster than
its revenue now today i think you could argue that amazon is in this phase of its development
so we're not quite to the point yet when the p e ratio tells the full story but we're much closer
to the p e ratio being a useful figure than we were a few years ago yeah it's only in stage
four where it really makes sense to use the p e ratio as a valuation metric because the p e ratio
assumes that a company is optimized for profits and free cash flow amazon still isn't there yet
but it is getting closer on the flip side if we are looking at a company that's in decline then
the p e ratio is useless in the other direction a stock may look very cheap but that's because the
earnings are high while the share price is going down because wall street knows that this business
is failing and going towards zero don't let that fool you either that's right if a company's
revenue and profits are both heading towards zero even if you buy at a p e ratio of one two or three
you're still gonna lose money well we hope you found this video useful operating leverage is
a key concept to understand if you're investing especially in companies that aren't in that fourth
stage of growth once you learn how to use it it can help you become a better investor brian's out