What is it: Rule of 40 is the idea that revenue growth rates plus profitability margins should be equal to or greater than 40%. Venture capitalists came up with this simple method to decide whether or not to invest in young software start-ups. It is a rule-of-thumb for sizing up the health of a software business, by taking into consideration two of their most important metrics: growth and profitability.1
Rule of 40 for stock selection
Rationale: The growth and profitability of a company are usually at odds with each other. To drive growth, the company would need to incur expenses. Finding the right mix or balance between the two can be tricky. Rule of 40 tries to balance and provide a trade-off between them. Investors are usually willing to tolerate low profits or even losses as long as a company is demonstrating strong growth.2
How to calculate: Take the example of Company A whose revenue is growing at 20%. According to the Rule of 40, it should be generating an EBITDA – earnings before interest, taxes, depreciation and amortisation – margin of at least 20%. Add the two numbers together. The higher the total number above 40%, the more attractive the company is for investment. A score above 40 is considered a passing grade while a score below 40 means failing the test.3
Why use EBITDA? Every company’s capital and entity structures are different. So is the way they apply accounting standards to the capitalisation of their fixed or intangible assets.
EBITDA helps investors compare apple-for-apple by stripping out interest from debt, differences in taxation and accounting policies across companies.4
Application: The criterion was initially used as a quick health check for software-as-a-service (SaaS) companies. Its application, however, has extended to most software companies. Young companies which are usually loss-making will have to beat the 40% mark with higher revenue growth. Older mature companies, whose growth has usually tapered off, will have to focus on improving their profit margins to meet the 40% mark.
Limitations: Implementing Rule of 40 across a short timespan may yield unreliable results. This is because consistent strong performances are difficult to maintain. It is important to measure performance across multiple years to derive a more accurate representation. In a Bain & Company research of 86 companies from 2013 to 2017, just 25% outperformed the Rule of 40 for three or more years. Only 17% outperformed in all five years.5
How you can use it: You can use the Rule of 40 as a stock-selection criterion for high-growth companies. These companies tend to spend heavily on sales, marketing and research and development to spur their revenue growth. Rule of 40 helps you sift out companies that are not yet profitable but offer strong revenue growth prospects. Today, many investors use it to assess any fast-growing digital-economy company.6
We do not base our recommendations entirely on the above quantitative return bands. We consider qualitative factors like (but not limited to) a stock`s risk reward profile, market sentiment, recent rate of share price appreciation, presence or absence of stock price catalysts, and speculative undertones surrounding the stock, before making our final recommendation
This publication is prepared by Phillip Securities (Hong Kong) Ltd (“Phillip Securities”). By receiving or reading this publication, you agree to be bound by the terms and limitations set out below.
This publication shall not be reproduced in whole or in part, distributed or published by you for any purpose. Phillip Securities shall not be liable for any direct or consequential loss arising from any use of material contained in this publication.
The information contained in this publication has been obtained from public sources which Phillip Securities has no reason to believe are unreliable and any analysis, forecasts, projections, expectations and opinions (collectively the “Research”) contained in this publication are based on such information and are expressions of belief only. Phillip Securities has not verified this information and no representation or warranty, express or implied, is made that such information or Research is accurate, complete or verified or should be relied upon as such. Any such information or Research contained in this publication is subject to change, and Phillip Securities shall not have any responsibility to maintain the information or Research made available or to supply any corrections, updates or releases in connection therewith. In no event will Phillip Securities be liable for any special, indirect, incidental or consequential damages which may be incurred from the use of the information or Research made available, even if it has been advised of the possibility of such damages.
Any opinions, forecasts, assumptions, estimates, valuations and prices contained in this material are as of the date indicated and are subject to change at any time without prior notice.
This material is intended for general circulation only and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. The products mentioned in this material may not be suitable for all investors and a person receiving or reading this material should seek advice from a financial adviser regarding the suitability of such products, taking into account the specific investment objectives, financial situation or particular needs of that person, before making a commitment to invest in any of such products.
This publication should not be relied upon as authoritative without further being subject to the recipient`s own independent verification and exercise of judgment. The fact that this publication has been made available constitutes neither a recommendation to enter into a particular transaction nor a representation that any product described in this material is suitable or appropriate for the recipient. Recipients should be aware that many of the products which may be described in this publication involve significant risks and may not be suitable for all investors, and that any decision to enter into transactions involving such products should not be made unless all such risks are understood and an independent determination has been made that such transactions would be appropriate. Any discussion of the risks contained herein with respect to any product should not be considered to be a disclosure of all risks or a complete discussion of such risks.
Nothing in this report shall be construed to be an offer or solicitation for the purchase or sale of a security. Any decision to purchase securities mentioned in this research should take into account existing public information, including any registered prospectus in respect of such security.
Disclosure of Interest
Analyst Disclosure: Neither the analyst(s) preparing this report nor his associate has any financial interest in or serves as an officer of the listed corporation covered in this report.
Firm`s Disclosure: Phillip Securities does not have any investment banking relationship with the listed corporation covered in this report nor any financial interest of 1% or more of the market capitalization in the listed corporation. In addition, no executive staff of Phillip Securities serves as an officer of the listed corporation.
If Distribution is to Australian Investors
This report is produced by Phillip Securities (Hong Kong) Ltd and is being distributed in Australia by Phillip Capital Limited (Australian Financial Services License No. 246827). This report contains general securities advice and does not take into account your personal objectives, situation and needs. Please read the Disclosures and Disclaimers set out above. By receiving or reading this report, you agree to be bound by the terms and limitations set out above. Any failure to comply with these terms and limitations may constitute a violation of law. This report has been provided to you for personal use only and shall not be reproduced, distributed or published by you in whole or in part, for any purpose. If you have received this report by mistake, please delete or destroy it, and notify the sender immediately.