Using the Rule of X
Rule of X, adapted from the more widely known Rule of 40, is a metric used to compare growing cloud computing companies. In this article, we will cover how to apply Rule of X using the free Rule of X tool featured here on Valuations.cloud.
Comparison to Rule of 40
General Formula
The formula for Rule of X is similar to Rule of 40 with the exception being that a multiplier gets applied to the growth rate. This means that the growth rate will have a bigger impact on the overall score than Free Cash Flow (FCF) Margin. The Rule of 40 applied an equal weight to revenue growth and FCF margin. The typical range of the multiplier is typically between 1.5 and 3. We use 2 by default on the Rule of X page, but this is configurable. The formula is as follows:
Rule of X = (Growth Rate * Multiplier) + FCF Margin
The range of outcomes will differ depending on what multiplier you decide to use. Since there is no established, fixed number like there is when using Rule of 40, a score of 60 should be reasonable when using a multiplier of 2.
An Argument for Favoring Growth
When considering a typical company's life cycle, there is a considerable lag between revenues and profits during a rapid growth phase. In the chart below, revenue grows at a faster rate until the company begins to mature. During the maturing phase, profits are still growing quickly while revenue start to taper. This is why it's important to understand what part of the cycle a company is in before investing.
Valuations Across the Life Cycle (Damodaran)
Using the Rule of X
On our Rule of X page, we make it flexible in that you can set whatever multiplier you want. You can also filter for only emerging cloud companies with minimum revenue growth requirements.
For this example, we will require the following:
- company must be in the BVP Nasdaq Emerging Cloud Index (EMCLOUD)
- revenue growth must be greater than 15%
- a growth multiplier of 3
The screenshot shows that by setting the filters above, we've already reduced our results down to 46. The EMCLOUD index currently has 65 companies in it. Our top-ranking results are as follows:
The rankings are based on the overall Rule of X score along with Enterprise Value to Revenue (EV/Revenue), which is our valuation metric. We want EV/Revenue to be lower and the Rule of X score to be higher. Color codes are included in the table to make this more clear. By requiring a minimum revenue growth target, we can eliminate any companies that are considered "cheap" by valuation standards but are not growing as fast as we'd like. That is, a company with a valuation low enough can still rank high if the valuation makes up for the lack of revenue and profitability.
"Value" companies can still make excellent investments in some cases. However, Rule of X is better designed for comparing companies that are consistently growing at a fast clip. Generally speaking, the higher the growth rate, the bigger impact compounding will have over time.
The bubble chart that appears further down the page plots each result with Rule of X on the x-axis and EV/Revenue on the y-axis. The results that appear in green represent companies that are undervalued when comparing their Rule of X result with their valuation metric.
One thing you'll quickly notice is that many of the great performing companies are frequently overvalued. If only slightly overvalued, an investment will often still do well if the company has a great moat and achieves great FCF margins once scale has been reached. Scale is important for many of these companies due to the benefits of reduced costs and network effects.
If a company you like is too overvalued, simply add it to your watchlist. Part of achieving great returns is the avoidance of overpaying. For most great companies, there will be multiple buying opportunities in the future.
Our suggested way of applying the Rule of X can be done using the following steps:
- Build a list of great Rule of X companies
- Monitor their valuations and performance over time
- Buy when they become undervalued or fairly valued