Why Aim for the Rule of 40 (R40) for the Software Stocks in Your Portfolio?

Table of Contents:

1. Rule of 40 formula

2. What does R40 measure?

3. Is R40 applicable for all companies?

4. Where to find R40 information for companies you are interested in?

5. R40 is useful to analyse fast growing companies which are not profitable yet.
   

Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.

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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.

50 Biggest Saas Companies listed on US Stock Exchanges as of 22 Mar 2024

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:

1. 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.

2. Efficient Operations:  A high profit margin indicates efficient use of resources. These companies can reinvest earnings back into growth, further fueling their success.

3. 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/.

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