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 growth company should have a combined revenue 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

Our Approach

A number of variations to the Rule of 40 exist. We use Free Cash Flow (FCF) Margin instead of Profit or Operating Margin on Valuations.cloud. This has shown to perform better than the alternatives.

Growth-Margin Trade-off

A company can sacrifice margin to create growth and vice versa. Because of this, it's generally best to see a balance between the two. However, a company early in its growth stage will prioritize revenue growth over FCF Margin.

Free Cash Flow (FCF) Margin is an alternative measure of profitability that reveals how much cash a company generates from its revenues. As a general rule, we prefer an FCF Margin of at least 20%.

FCF offers some useful alternatives to net income. It excludes non-cash expenses and includes capital expenditures. Not only is it more difficult to manipulate than earnings, it can also reveal potential problems earlier.

General Formula

FCF Margin = (Operating Cash Flow - CAPEX) / Revenue

As a general rule, earnings and free cash flow should be in sync. That is, they should be rising over long periods of time at roughly the same rate. If these are diverging, it should require further investigation. For example, are accounts receivable growing at a faster rate than earnings? If so, it could mean that sales aren't turning into cash.

Another red flag is when companies have too many "one time" capital expenditures. This too, requires further research to determine if these become permanent which will a drag on future cash flows.

Detailed Formula

Related

• Free Cash Flow

Enterprise Value (EV) to Revenue is our preferred price-to-sales metric. On our Rule of 40 and SaaS/Cloud Valuations pages, bubble charts are included to help determine whether a company is fairly valued.

The goal of using EV to Revenue is to find an attractive company for the price. For example, using our Rule of 40 model, a number of companies can satisfy our growth and profit margin targets. However, this by itself doesn't make a company a good investment. Combining the model with EV to Revenue can prevent you from overpaying for a stock.

For SaaS/Cloud companies, EV to Revenue will be much higher than the typical company. This is due to software companies being able to create enormous value with few assets, resulting in large profit margins. As a result, it's important to make comparisons among similar companies within the same industry as well as historic averages.

Enterprise Value is preferred over Market Cap because it takes debts and cash balances into account. An in-depth comparison can be found here: Enterprise Value vs. Market Capitalization: What's the Difference?

High insider ownership is correlated with good performance. Generally speaking, executives that own larger portions of a company are more motivated to make it succeed in the long run, not just for the next quarter.

We like to see insider ownership of 10% or higher. Even though insider ownership is preferred, it's not a dealbreaker. Some companies have been sensational despite being owned mainly by institutions.

Insider buying is bullish for a stock. Insider selling, on the other hand, doesn't have much correlation to performance (surprisingly). The difference could be that insider buying takes place when insiders expect the company to do well. Conversely, there are a number of different reasons for selling, such as diversification, philanthropy, or any life-changing event.