Many investors don't understand the term "operating leverage" when they're starting out. But trust me, the smartest investors do. In this article, I'll attempt to demonstrate what operating leverage is, using the home rental platform Airbnb (ABNB 0.75%) as an example.
Smart investors know that Airbnb possesses a business model with inherent operating leverage built in. And it's one of the reasons it should be near the top of any investor's watch list.
The power of Airbnb's model
It's surprising to some newer investors that profitability can be measured from multiple angles. When assessing a business model, looking at the operating margin can be helpful. The net-profit margin also includes things like taxes and financing arrangements. These items are important, but they aren't directly related to operating the business.
In Airbnb's case, it has a stellar operating margin, recently outperforming peers like Expedia Group and Marriott International.
ABNB Operating Margin (TTM) data by YCharts
Through the first three quarters of 2022, Airbnb has generated revenue of $6.5 billion and its income from operations is nearly $1.6 billion. This puts the company's operating margin at 24% for this period.
Now, here's where I'll demonstrate Airbnb's operating leverage: Through the first three quarters of 2022, Airbnb has generated about $2 billion more in revenue than during the comparable period of 2021. Because its operating margin is 24%, you'd expect that the extra $2 billion in revenue would bring in $480 million in extra income from operations. But that's not even close to being the case.
In reality, Airbnb has generated $1.2 billion more in income from operations in 2022 compared to 2021. That means that of the incremental $2 billion it's generated in revenue, 60% has dropped straight to the bottom line from an income-from-operations perspective.
When additional revenue comes with no additional costs to speak of, that's a boost to the company's operating leverage. And Airbnb flexed that muscle big time in 2022.
Why operating leverage matters
Not all business models are built with inherent operating leverage. For example, take a company like Domino's Pizza. Franchisees can gain operating leverage at their restaurant locations with higher sales. But franchisor Domino's is primarily generating revenue from franchise fees and selling supplies to restaurants in its system, which doesn't really give it a whole lot of operating leverage with scale, as the 10-year chart below shows.
DPZ Revenue (TTM) data by YCharts
That's not to say Domino's can't be a good stock to own -- it's actually been a phenomenal stock to own over the last decade. It has been able to overcome this shortcoming with other positive traits. However, Domino's does illustrate a point for our purposes here: Not all business models can demonstrate operating leverage to the same degree that Airbnb's has.
Airbnb has operating leverage because it's simply providing a platform to connect hosts with travelers. This is merely a technology platform that needs little extra spending to handle increased volume. Every time a new host joins the platform and a new guest books a stay, Airbnb reaps the reward from what it's already built.
Again, not all businesses are built this way. As famous investor Warren Buffett wrote in 1992, "The worst business to own is one that must ... consistently employ ever-greater amounts of capital at very low rates of return." In other words, some companies spend a lot more to make a little more.
Newer investors tend to only look at growth. But I hope it's clear that not all growth is equal. Only select companies unlock greater profit potential with growth, and those are the companies investors are after.
Earlier in Buffett's 1992 letter, he says this discussion is aside from the discussion about whether a stock is a good value opportunity or not. And indeed, I haven't looked at whether Airbnb stock is a timely buy or not. That's a separate discussion entirely.
However, I have noted Airbnb's incredible demonstration of operating leverage in 2022 and why this is a desirable trait. For this reason, I'd recommend putting Airbnb on your watch list if it isn't already -- it's a good business to own.
From here, I'd suggest familiarizing yourself with the home rental space to see where the industry is headed in the coming year and beyond. And take a look at Airbnb's valuation, to see whether it could be a good stock to buy right now.
