Abstract
The asset pricing literature demonstrates a positive association between operating leverage and expected stock returns. We uniquely examine the predictive power of operating leverage on expected stock returns, in light of the industry returns to scale. Our inspection starts with a theoretical illustration of this facet, demonstrating higher sensitivity of operating profits to production inputs along higher level of production returns to scale. We then empirically examine 83,415 firm-year observations in the US manufacturing industry between 1963 and 2011. We find that the positive and significant relation between operating leverage and the cross-section expected stock returns appears only when the production returns to scale are high. Low returns to scale, however, alleviates both the economic and statistical significance positive effect.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Later on, we apply the theoretical illustration to the case of decreasing returns to scale.
Note that even under perfect competition, where we assume decreasing returns to scale in which output elasticity is smaller than one, the higher is output elasticity we would expect a relatively higher variability of revenues than that of costs.
References
Artikis, P. G., & Nifora, G. (2011). The industry effect on the relationship between leverage and returns. Eurasian Business Review, 1(2), 125–145.
Basu, S., & Fernald, J. G. (1997). Returns to scale in US production: Estimates and implications. Journal of Political Economy, 105, 249–283.
Burnside, C. (1996). Production function regressions, returns to scale, and externalities. Journal of Monetary Economics, 37, 177–201.
Carlson, M., Fisher, A., & Giammarino, R. (2004). Corporate investment and asset price dynamics: Implications for the cross-section of returns. Journal of Finance, 59, 2577–2603.
Fama, Eugene F., & Macbeth, J. (1973). Risk, return and equilibrium: Empirical tests. Journal of Political Economy, 81, 607–636.
Fama, Eugene F., & French, K. (1992). The cross-section of expected stock returns. Journal of Finance, 2, 427–465.
Hall, R. E. (1988a). The relation between price and marginal cost in US Industry. Journal of Political Economy, 96, 921–947.
Hall, R. E. (1988b). Invariance properties of Solow’s productivity residual. In P. Diamond (Ed.), Growth productivity unemployment: Essays to celebrate Bob Solow’s birthday (p. 1990). Cambridge: MIT Press.
Lev, B. (1974). On the association between operating leverage and risk. Journal of Financial and Quantitative Analysis, 9, 627–641.
Novy-Marx, R. (2011). Operating leverage. Review of Finance, 15, 103–134.
Yogo, M. (2006). A consumption-based explanation of expected stock returns. Journal of Finance, 61(2), 539–580.
Acknowledgments
We thank Ilan Cooper, Yakov Amihud, Doron Avramov, and seminar participants at Tel Aviv University, the Hebrew University of Jerusalem, and Ariel University, for their helpful comments. Financial support from the Rosenfeld Foundation is gratefully acknowledged.
Author information
Authors and Affiliations
Corresponding author
Additional information
This paper is dedicated to the memory of our mentor, Professor Simon Benninga.
Rights and permissions
About this article
Cite this article
Taussig, R.D., Akron, S. Returns to scale, operating leverage, and expected stock returns. Eurasian Bus Rev 7, 141–155 (2017). https://doi.org/10.1007/s40821-016-0053-5
Received:
Revised:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s40821-016-0053-5