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In our quest to build a winning stock portfolio, we need companies with strong growth potential.
Today, we'll explore the Rule of 40 (R40), a powerful metric to identify such companies.
Rule of 40 formula
Rule of 40 (R40) will be met when: Revenue Growth Rate + EBITDA Margin => 40% [1]
However, if you would like to use a more stringent formula, you could opt for this version instead: "Revenue Growth Rate + Profit Margin" but do note that most of calculation for R40 is calculated based on the first formula.
What does R40 measure?
It measures a company's ability to balance growth and profitability.
A high growth rate signifies the company's top line is expanding rapidly,
while a strong profit margin indicates it's generating healthy earnings.
Is R40 applicable for all companies?
The R40 is most relevant for Software-as-a-Service (SaaS) companies.
These businesses typically boast recurring revenue streams and high margins due to the lower cost of delivering their services.
The Power of R40: Evidence for Success
Studies have shown that SaaS companies exceeding the R40 tend to outperform the market over the long term.
Here's why:
Sustainable Growth: Companies hitting the R40 demonstrate the ability to grow quickly while maintaining profitability. This suggests a strong business model with a loyal customer base.
Efficient Operations: A high profit margin indicates efficient use of resources. These companies can reinvest earnings back into growth, further fueling their success.
Investor Confidence: Companies exceeding the R40 are often viewed favorably by investors, leading to higher valuations and potentially greater returns.
Where to find R40 information for companies you are interested in?
While there are sites that collates R40 values such as https://ruleof40.trade/.
I would advise that you cross check them yourself using the formula provided above.
For example, to find out the R40 for Fortinet,
You can obtain both the Revenue Growth & EBITDA Margin figures from a site like stockanalysis.com, and add them together.
Giving us a total value of 46.97%.
This means Fortinet meets the Rule of 40.
Benefit of R40: useful to analyse fast-growing companies which are not profitable yet
For new growth companies, it is not unusual for them to operate at a loss during their first few years since they may be prioritising on reinvesting back into their businesses to capture more market share (growth).
The Rule of 40 will be useful to analyse these kind of companies.
Similarly, the PS ratio will be useful to evaluate the valuation of these companies too (to learn more, read: Why Price to Sale ratio is the one of the best valuation ratio for finding undervalued stocks.)
Conclusion
Remember, The R40 is a guideline, not a rigid rule. Some exceptional companies may fall below 40% in one metric but excel in the other. However, it serves as a valuable starting point to identify businesses with the potential for significant growth and strong financial health.
