Rule of X

Rule of X is a metric used to evaluate a company based on growth and profitability with more weight being placed on growth. Growth and margin can be used together to give an indication of a firm's performance.

Formula

By default, we use a value of 2 as the growth multiplier. There is a dropdown that enables you to change this. Based on BVP's recommendations, 2 is a fairly conservative value, while anything greater than 3 is considered aggressive.

Benefits and Drawbacks

The benefit of using Rule of X is that it can reveal opportunities other investors passed on. A company's current valuation is a function of its future (long-term future in many cases). In an industry that's growing and changing fast, there often is a tremendous first mover advantage. Capturing market share quickly can create barriers to entry, network effects, and achieve scale. Therefore, by having profit margin standards that are too strict, you may be missing out on home runs. As the company approaches maturity, it can gradually shift its focus to profitability.

The potential drawback of this model is that too much emphasis is being given to growth for a company in which its product(s) will never achieve the expected pricing power. That is, the company will never have a satisfactory profit margin. There are cases where a product can reach a critical mass as long as its priced low enough (or heavily marketed but not profitable). At that point, either scale needs to be reached or prices need to increase. If neither of these happen, the company will disappoint, causing its stock price to fall.

It's also worth noting that the macro environment can have a significant impact on what to use as a multiplier. During periods of tight money and high interest rates, financing will be more expensive and harder to obtain. This has been the case since mid 2022. Prior to 2022, zero-bound interest rates made cheaper and easier to acquire financing. This helped companies concentrate on growth and not be as concerned with profit margins. In tighter money environments, a more conservative multiplier should be used.