Rule of 40 for stock selection March 24, 2021
What is it: Rule of 40 is the idea that revenue growth rates plus profitability margins should be equal to or greater than 40%. Venture capitalists came up with this simple method to decide whether or not to invest in young software start-ups. It is a rule-of-thumb for sizing up the health of a software business, by taking into consideration two of their most important metrics: growth and profitability.1
Rationale: The growth and profitability of a company are usually at odds with each other. To drive growth, the company would need to incur expenses. Finding the right mix or balance between the two can be tricky. Rule of 40 tries to balance and provide a trade-off between them. Investors are usually willing to tolerate low profits or even losses as long as a company is demonstrating strong growth.2
How to calculate: Take the example of Company A whose revenue is growing at 20%. According to the Rule of 40, it should be generating an EBITDA – earnings before interest, taxes, depreciation and amortisation – margin of at least 20%. Add the two numbers together. The higher the total number above 40%, the more attractive the company is for investment. A score above 40 is considered a passing grade while a score below 40 means failing the test.3
Why use EBITDA? Every company’s capital and entity structures are different. So is the way they apply accounting standards to the capitalisation of their fixed or intangible assets.
EBITDA helps investors compare apple-for-apple by stripping out interest from debt, differences in taxation and accounting policies across companies.4
Application: The criterion was initially used as a quick health check for software-as-a-service (SaaS) companies. Its application, however, has extended to most software companies. Young companies which are usually loss-making will have to beat the 40% mark with higher revenue growth. Older mature companies, whose growth has usually tapered off, will have to focus on improving their profit margins to meet the 40% mark.
Limitations: Implementing Rule of 40 across a short timespan may yield unreliable results. This is because consistent strong performances are difficult to maintain. It is important to measure performance across multiple years to derive a more accurate representation. In a Bain & Company research of 86 companies from 2013 to 2017, just 25% outperformed the Rule of 40 for three or more years. Only 17% outperformed in all five years.5
How you can use it: You can use the Rule of 40 as a stock-selection criterion for high-growth companies. These companies tend to spend heavily on sales, marketing and research and development to spur their revenue growth. Rule of 40 helps you sift out companies that are not yet profitable but offer strong revenue growth prospects. Today, many investors use it to assess any fast-growing digital-economy company.6
Please feel free to email us at firstname.lastname@example.org if you have questions about applying Rule of 40 to your stock selections.