Using Estimated Revenue Growth with the Rule of 40

When using tools like the Rule of 40 and the Rule of X, it's important to consider which revenue growth figure to use. Generally, the options are as follows:

Trailing or Last Year (LY): actual numbers from the most recently released financial statements
Current Fiscal Year (CY): estimates cover the remainder of the current fiscal year
Next Fiscal Year (NY): estimates for the next fiscal year

Analysts typically don't go beyond the next fiscal year. Even if they did, the accuracy would generally be poor, like forecasting the weather 10 days into the future. The next year is difficult enough. Analyst earnings also tend to be on the optimistic side and are prone to revisions. So, that's something to keep in mind. I do, however, believe it to be worthwhile to compare trailing revenue growth to estimated revenue growth. Any wide swings from one year to the next require further investigation when researching a company.

Previously, the Rule of 40 and Rule of X pages on Valuations.cloud had been using only the trailing revenue growth numbers. In the latest enhancement, the user now has the option to select a different revenue growth option. Simply click the options button to open the adjustments section:

select revenue growth options

Switching from the trailing revenue growth amount to one of the estimated options can change the results dramatically. Both the materialized and the estimated growth values should be considered with an emphasis on how much the results vary among these options. Next, we'll walk through a specific example.

Specific Company Example

For this example, we will be using the Rule of X model using a revenue growth multiplier of 2. (View the Rule of X description to see how the formula works)

Rule of X result trailing revenue

In the results table, BILL Holdings has a top ranking with revenue growth of 64.88% and a Rule of X score of 150.50. Since revenue growth of over 60% is very high, we can now check expected future revenue growth. We will change the revenue growth to be based on the FY 2024 estimate. On the Rule of X page, click the options button and select the appropriate option from the revenue growth dropdown (see screenshot near top). Scroll down to see the updated results in the table:

Rule of X result current year estimated revenue

In the updated results, BILL's ranking fell to 8th place. Revenue growth slowed to 17.39%. The Rule of X score is still pretty good when factoring in Free Cash Flow (FCF) Margin. Valuation, with an EV to Revenue of 4.1 also helps its ranking. We will now check the results for the 2025 estimated revenue growth:

Rule of X result 2025 estimated revenue

Based on the 2025 estimated results, BILL's ranking is back up to 2. It's important to note that one of the difficulties when using the Rule of X (and Rule of 40) is that high revenue growth is hard to sustain. Based on the results, BILL is consistently in the top 10. And along with a reasonable valuation, it appears to be an attractive investment based on the Rule of X model.

Concluding Thoughts

Given that a stock's price is a function of its future, it's vital to analyze where revenue and cash flows are heading. This feature enhancement is intended to help solve the problem of companies that had strong revenue growth numbers in the past becoming attractive from a valuation standpoint due to falling stock prices. Using historical data will often cause a stock to rise in the rankings. It's ranking will be too high if the future is worse than the past.

In order for a stock to be a great investment opportunity, it's important for the investor to distinguish between a stock that has oversold and is now trading at or below its fair value versus a stock that's sold off because the future is no longer bright. In addition to using forward estimated revenue numbers, an evaluation of the company's long-term competitive advantage will be vital also.