Why Rule of 40?
"Rule of 40" has become a popular benchmark in the Cloud/SaaS (Software as a Service) industry. In this article, we will explain its importance and why these types of alternative methods are needed for this industry.
Problems with Valuing Tech Companies
Since tech companies are structured far differently form older industrial companies, newer approaches are needed to place valuations on them. There are several reasons for this. Before we dive in, we’ll briefly go over what the Rule of 40 is.
What the Rule of 40 Is
Rule of 40 is a metric used to evaluate a company based on growth and profitability. Growth and margin can be added together to give an indication of a firm's performance.
The number "40" is based on the idea that an attractive SaaS/Cloud company should have a combined growth and profit margin of at least 40. When using this rule, it is assumed that the company is in its growth stage and the payoff will be great in the future.
General Formula
Rule of 40 = Revenue Growth Rate + Profit Margin
A number of variations to the Rule of 40 exist. We use Revenue Growth and Free Cash Flow (FCF) Margin (instead of Profit or Operating Margin) on Valuations.cloud. This has shown to perform better than the alternatives. In fact, combining FCF and Revenue Growth historically has been proven to be the best combination after testing many different Rule of 40 variations 1.
There may be better alternatives than combining Revenue and FCF, such as Annual Recurring Revenue (ARR). However, reporting ARR publicly is a choice the company has, whereas FCF can be derived from standard financial statements. Since we don't live in a world where data is as consistently available as we'd like, we need to stick to something that can be applied reliably across all companies.
FCF is also harder to manipulate than earnings. Cloud and SaaS companies particularly have had to deal with deciding whether something is a capital expenditure or an operating expense. This depends on how accounting conventions are interpreted. FCF also accounts for marketing costs. Which would be left out if using gross profit instead. In the end, both CAPEX and operating expenses are taken into consideration. At Amazon, Jeff Bezos has always stated in his annual letters that he prefers FCF.
More marketing obviously creates more growth. However, if too much is spent on marketing in comparison to the number (and degree of profitability) of the newly acquired customers, it will eat into FCF margins. This can also help expose cases where a company seems to be growing quickly but has too much attrition.
Problems with Traditional Valuation Methods
Growing software companies have a few characteristics that make them different from older, traditional companies. The first difference is a lack of fixed assets. Building software doesn’t involve factories or expensive equipment. Many companies use computing resources in the cloud on a pay-as-you go basis. This allows product to be scaled up almost instantly without dishing out massive capital expenses.
Second, most growing tech companies prioritize gaining market share over short-term profits with the intent that profitability will be achieved over time. That is, more customers spread out over the same fixed costs will lead to an expanding FCF margin. Even if customer acquisition costs (CAC) are relatively high, they can still prove to be profitable if attrition rates are low and they lead to Annual Recurring Revenue (ARR).
Discounted Cash Flows (DCF)
Discounted cash flows (DCF) have been ineffective with valuing companies that are currently unprofitable but will be worth billions in the future. The formula takes in estimated future cash flows then applies a discount rate to determine what the investment is worth today (see https://investopedia.com/terms/d/dcf.asp). Another drawback of this approach is that future cash flows are highly uncertain.
Traditional Price Valuation Multiples
We rely more on Price to Sales (specifically EV/Revenue) multiples rather than the more traditional Price to Earnings (PE) or Enterprise Value to EBITDA (EV/EBITDA). Growth companies, typically having negative earnings for years before gaining enough market share, will have negative values for these figures. As a result, we focus more heavily on top-line revenue growth.
For a growth company, the relationship between top line revenue and profits has a lag. 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. This is a big part of why most tech growth companies commonly appear to be overpriced.
Valuation Issues Across the Life Cycle (Damodaran)
Tech companies have a number of fixed costs that involve maintaining software and keeping the lights on. As customer count and revenues grow, fixed costs should shrink as a percentage of sales. This explains why profits often surge just as a company is reaching maturity.
Growth-Margin Trade-off
A company can sacrifice margin to create growth and vice versa. Because of this, we generally want to see a balance between the two. Newer companies, however, tend to prioritize growth over margins. Their primary goal is to gain market share. Most successful companies in this class will experience declining costs along with the gains in market share. This also has an added benefit of fending off competition.
At Amazon, Jeff Bezos always prioritized long-term growth over short-term profitability. This was clearly expressed in his annual shareholder letters. He kept reiterating the need to keep costs low, investing in processes that reduced friction (i.e. “buy with 1 click” feature), and offering free shipping.
Of course, the end game for Jeff Bezos was always to be profitable. Wall Street, however, was judging Amazon by the next quarter or the next year. And Bezos's focus was many years down the road. In hindsight, the strategy seems like a no brainer. But no other online retailers were using this strategy at the time. At least not with the intensity that Amazon was.
If a company has a massive growth rate and small (or negative) margins, the company needs to have a compelling argument as to how it will be profitable in the future. This is another reason why we use free cash flow (FCF) over alternatives like EBITDA. If cash flow is negative, the company will have a difficult time sustaining itself without obtaining more money from investors. The goal is to avoid situations where a company is overinvesting in growth but can never achieve pricing power or economies of scale. Not to mention high attrition rates that negatively impact ARR.
Sustaining the Rule of 40 is Hard
As a company matures, it should become more profitable and grow at a slower rate. The likelihood of a maintaining the Rule of 40 standard is low.
McKinsey research finds that barely one-third of software companies achieve the Rule of 40. Fewer still manage to sustain it. Analysis of more than 200 software companies of various sizes between 2011 and 2021 found that businesses exceeded Rule of 40 performance only 16 percent of the time.
Read the McKinsey & Company article here2
Whether or not a company can maintain this benchmark depends a lot on the company's moat. Analyzing a company's moat requires analyzing qualitative measures. Some quantitative metrics can help with this. A couple that come to mind are ARR and attrition rate. High attrition is a problem because it costs more to acquire new customers than continuing to sell to the same customers.
As a result, we expect smaller companies to prioritize growth more than FCF margins, while medium to large companies should put a higher priority on FCF margins.
References
2SaaS and the Rule of 40: Keys to the critical value creation metric