Leverage

What is 'Leverage'

Leverage is the investment strategy of using borrowed money: specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets. When one refers to something (a company, a property or an investment) as "highly leveraged," it means that item has more debt than equity.

The Difference Between Leverage and Margin

Although interconnected – since both involve borrowing – leverage and margin are not the same. Leverage refers to the act of taking on debt. Margin is a form of debt or borrowed money that is used to invest in other financial instruments. A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options or futures contracts in the anticipation of receiving substantially high returns.

In short, you can use margin to create leverage.

BREAKING DOWN 'Leverage'

How Does Leverage Work?

At automobile dealerships, a significant number of car shoppers leave the lot with a brand new car, even though they could not afford to pay for that car in cash. To obtain the car, these buyers borrowed the money. They then gave the borrowed money to the car dealer in exchange for the vehicle.

If the cost of a vehicle is $20,000 and a buyer hands over $2,000 in cash and $18,000 in borrowed money in exchange for the vehicle, the buyer’s cash outlay is only 10% of the vehicle’s purchase price. Using borrowed money to pay 90% of the cost enables the buyer to obtain a significantly more expensive vehicle than what could have been purchased using only available personal cash. From an investment perspective, this buyer was levered 10 to one (10:1). That is to say, the ratio of personal cash to borrowed cash is $1 in personal cash for every $10 spent.

Now, let’s take the example a step further. If the buyer in our automobile example was able to drive away from the dealership and immediately sell that car for $22,000, the buyer would pocket $2,000 in profit from a $2,000 investment, ignoring the interest expense. Mathematically speaking, that would be a 100% return on the buyer’s investment. By contrast, consider the case if the buyer has paid cash for the car, without taking out a loan, and then immediately sold the car for $22,000. With a $20,000 initial investment resulting in $2,000 profit, the buyer would have generated a 10% return on the investment. While a 10% return is certainly nice, it pales in comparison to the 100% return that could have been generated using leverage.

Other Types of Leveraged Investment

  • Leverage can be applied to real estate. Consider a real estate investor who has $50,000 in cash. That investor could use that money to buy one home valued at $50,000. If that home could be quickly sold for $55,000, the investor would have gained $5,000. If that same investor used the original $50,000 in cash to put a $5,000 down payment on 10 different homes valued at $50,000 each, financed the rest of the money, and then sold all 10 homes for $55,000 each, the investor’s profit would have been $50,000 – an astounding 100% return on investment. Or, suppose that you own a leased property that you bought for $1 million and the property returns a net 15% each year; your return on investment is 15% per year. However, suppose that instead of paying $1 million in cash, you mortgage the property and borrow $800,000, and therefore only invest $200,000 of your own money. After paying the interest on the loan, you may only achieve an 8% return, rather than 15%. However, 8%, or $80,000, divided by your equity investment of $200,000 is actually equivalent to a 40% return on your investment.
  • Leverage can be used in a similar way in the stock market. Margin loans, futures contracts and options are a few of the more common methods by which investors add leverage to their portfolios. Just as in the real estate example, a limited amount of money can be employed to control a larger amount of stock than would be possible through a direct purchase made with available cash. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of a company's stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.
  • Bond-market investors can also use leverage. Consider a scenario in which the interest rate on a one-year loan is 1% while the interest rate on a 10-year loan is 5%. By borrowing money at the short-term rate and investing it at the long-term rate, an investor can profit from the difference in rates. In a deflationary environment, a negative-yield bond allows investors to hedge their investments against further declines If an investor purchases a bond with a -2% yield, the principal investment declines by only 2% by the time the bond matures. However, if the economy devalues by 4%, 6% or 8% over the same period, the 2% bond loss will have beaten the market, providing a smaller loss. If an investor leverages a bond in this market, the gain would be magnified.

How Companies Use Leverage

Investors who are not comfortable employing leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the normal course of their business to finance or expand operations – without having to increase their outlay.

For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million; this is the money the company can use to operate. If the company uses debt financing by borrowing $20 million, it now has $25 million to invest in business operations and more opportunity to increase value for shareholders. An automaker, for example, could borrow money to build a new factory. The new factory would enable the automaker to increase the number of cars it produces, thereby increasing profits.

Leverage Formulas

Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can choose to invest in companies that put leverage to work on behalf of their businesses. Statistics such as Return on Equity, Debt to Equity and Return on Capital Employed help investors determine how companies are deploying capital and how much of that capital has been borrowed. To properly evaluate these statistics, it is important to keep in mind that leverage comes in several varieties, including operating, financial and combined leverage.

Fundamental analysis uses the degree of operating leverage (DFL). The DFL is calculated by dividing the percentage change of a company's earnings per share (EPS) by its percentage change in its earnings before interest and taxes (EBIT) over a period. Similarly, the DFL could be calculated by dividing a company's EBIT by its EBIT less its interest expense. A higher DFL indicates a higher level of volatility in a company's EPS.

DuPont analysis uses something called the "equity multiplier" to measure financial leverage. The equity multiplier is calculated by dividing a firm's total assets by its total equity. Once figured, the financial leverage is multiplied with the total asset turnover and the profit margin to produce the return on equity. For example, if a publicly traded company has total assets valued at $500 million and shareholder equity valued at $250 million, then the equity multiplier is 2.0 ($500 million / $250 million). This shows that one half of the total assets of the company is financed by equity. Hence, larger equity multipliers suggest more financial leverage.

If reading spreadsheets and conducting fundamental analysis is not your cup of tea, you can purchase mutual funds or exchange-traded funds that use leverage. By using these vehicles, you can delegate the research and investment decisions to experts.

Downside of Leverage

Leverage is a multi-faceted and complex tool. The theory sounds great, and in reality the use of leverage can be quite profitable, but the reverse is also true. (For more on this view, see Forex Leverage: A Double-Edged Sword.) Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.

Let's revisit some earlier examples. Consider that automobile purchaser using leverage to acquire a $20,000 vehicle with a down payment of just $2,000. The minute that new car leaves the lot, its value drops because it is now a “used” car instead of a “new” one. So, that $20,000 car may be worth $19,000 just a few hours later. A month later, the buyer will need to make a payment in exchange for the $18,000 loan used to purchase the vehicle. More often than not, that loan charges interest. By the time the loan is paid off, once the interest payments are factored in, the buyer may have spent $25,000 or more for a vehicle that is now valued at $10,000. If the buyer had not used leverage to buy the car, the amount of money lost on the purchase would have been lower.

In the housing purchase example, the investor used five down payments of $5,000 each to purchase 10 homes valued at $50,000 each. If real estate prices fall and those homes are now worth only $45,000 each, the investor would take a $50,000 loss (100% of the initial amount invested) if the homes were sold. If the value of the homes fell to $40,000 each, the buyer’s potential loss of $100,000 is 200% of the original investment amount. In each scenario, the buyer would also need to continue making mortgage payments (including interest) and insurance payments in addition to periodic home maintenance. In this scenario, the losses can add up quickly and the amounts lost become substantial.

A similar concept applies to the fixed-income investor who took out a short-term loan at 1% interest to invest in a loan that paid 5%. If short-term interest rates rise to 6%, and the investor is only earning 5% on the long-term investment, the investor loses money.

A Leveraged Investment Scenario

Let's follow a leveraged investment as it builds equity, loses value, goes underwater and then recovers. An understanding of this process is critical for investors who use mortgage debt, margin debt, long-term call options, or other similar financial derivatives to build wealth.

Equity Formation
Leverage aims to use borrowed money to build equity by investing it at a higher rate. For example, if we can borrow $10,000 at 5% and invest it at 10%, we can make the difference between the investment gains and the interest, or $500, as long as the opportunity lasts.

Large profits are made when the assets in a leveraged investment compound at a higher rate than the debt over a long period of time. The above investment compounded for 10 years will generate $9,648.

Assets $10,000 x (1+10%)^10 = $10,000 x 2.5937 = $25,937
Debt $10,000 x (1+5%)^10 = $10,000 x 1.6289 = $16,289
Equity $25,937 - $16,289 = $9,648

The compounding investment gains provide an extra $5,937 ($25, 937 - $20,000) during the 10-year life of the investment and compound interest adds an additional $1,289 (16,289 - $15,000) of debt.

Note that if the investor is able to pay the interest out of pocket over the life of the investment, he or she can prevent the interest from compounding and save money. For example, this might mean regularly paying the interest on a margin balance.

The Leverage Ratio and Volatility
Leveraged investments have a starting equity and a specific leverage ratio based on the amount of equity compared to assets. For example, $1,000 of an investor's equity could be supplemented with $2,000 of borrowed capital to create an investment with three times the leverage.

The leverage ratio is useful shorthand for calculating percentage changes in equity based on a percentage change in assets. For example, if our underlying investment gains 10%, the equity in our three-times leveraged investment should increase by 30%. However, the leverage ratio doesn't factor in the cost of debt and isn't necessarily accurate for long time periods.

The volatility of the underlying assets can be multiplied by the leverage ratio to find the volatility of the equity. For example, a three-times leveraged investment will have three times the volatility of the same unleveraged investment.

Increased volatility is what pushes leveraged investments underwater. Every volatile investment has a chance to lose value, and when the volatility increases, scenarios that reduce or wipe out an investor's equity become much more likely.

Example: Negative Compounding
Suppose that we make a three-times leveraged $1,000 investment in an index fund with roughly 10% annual returns and 15% annual volatility. The interest rate on borrowed money is 5%.

On average, we would to gain $200 in the first year (($3,000 x 10%) - ($2,000 x 5%)), based on $300 worth of capital gains minus $100 in interest. However, an extremely wide range of returns is possible for our investment. We can predict possible scenarios using a standard distribution of returns based on statistical probabilities.

For example, 68% of the time we would expect our asset returns to be within one standard deviation of 10%, or between -5% to +25%. That leads to a range of equity returns of -25% to +65%. That's a lot of unpredictability. Also, 34% of the time the return on our investment would be outside that range, potentially returning +110% or -70% in the first year.

- % Asset Returns % Equity Returns
Expected Result +10% +20%
68% of results (1 std dev) -5% to +25% -25% to +65%
95% of results (2 std dev) -20% to +40% -70% to +110%
99.7% of results (3 std dev) -35% to +55% -115% to +155%

While it is still unlikely that all of our equity could be wiped out in the first year, it is easy to see how it could happen after a few years of poor investment returns. Given the above probabilities and using Monte Carlo methods, we can calculate that our investment would be underwater about 4% of the time after five years, and 3% of the time after 20 years.

Let's say that our fund loses 20% in the first year, which results in a 70% loss of equity. Of this loss, 60% is due to the 20% fall multiplied by three-times leverage, and 10% is a result of interest payments, although in this example we'll accumulate our interest.

- Starting Point After 20% Drop
Assets $3,000 $2,400 (fell $600)
Debt $2,000 $2,100 (rose $100)
Equity $1,000 $300
Leverage Ratio $3,000/$1,000 = 3 times $2,400/$300 = 8 times
Expected Asset Gains $3,000 x 10% = $300 $2,400 x 10% = $240
Interest Due $2,000 x 5% = $100 $2,100 x 5% = $105
Expected Profit $300 - $100 = $200 $240 - $105 = $135
Expected ROE $200/$1000 = +20% $135/$300 = +45%
Volatility of Equity 15% x 3 = 45% 15% x 8 = 120%

After the 20% loss, our leverage ratio increases from three-times to eight-times because we now have less equity in the investment compared to total assets. This sharply increases our expected return on equity and our expected volatility.

Even after this loss our investment could still recover, but given the razor-thin equity, it is also very possible that it could be pushed underwater. Although the probabilities slightly favor recovery, either scenario is likely,

Recovery
The gradual compounding of our investment gains is the tool that creates equity in a long-term leveraged investment. However, the volatility of the risky asset also has the potential to negatively compound the investment. Situations in which the asset is compounding at a negative rate but the debt is compounding at a positive rate lead to underwater investments.

However, in every time period our assets are still more likely to compound positively than negatively. This makes it statistically likely that our leveraged investment will recover, given time. This is true even when the expected return is low or negative, because as the leveraged investment accumulates assets, the expected return will eventually turn positive and the losses will be erased.

Still, this could take a long time. In the above example, if the level of debt ever gets to the point where it is 50% higher than the level of assets, then the investment is at least 10 years away from profitability, on average, and future negative returns would make this recovery period even longer.

Even though leverage is often seen as a "get rich quick" tool for short-term speculators, it is clear that leveraged investments reward both patience and thoughtful diversification.

The Bottom Line

Some people liken using leverage to a journey in a car. You could walk to your destination, but driving is a much more efficient solution, especially if the destination is far away. Driving a car is probably much riskier than walking, and statistically more people die in road accidents. But how many people listen to those statistics and never drive in a car? Like any potentially dangerous instrument, leverage must be handled carefully. But if you understand how leverage works and learn to handle it correctly, you can use its power to build wealth.