How To Pick Tech Stocks Using The Rule Of 40

How To Pick Tech Stocks Using The Rule Of 40
Paul Allison, CFA

over 1 year ago5 mins

  • The rule of 40 is used widely in the technology industry as a benchmark for firms looking to balance sales growth and profitability. Those that make the cut get rewarded with high valuations.

  • When trying to pick from the elite group, remember: firms that are able to balance a slowdown in sales growth with offsetting profitability improvements will generate the most cash, which is ultimately the most important thing for long-term investors.

  • The rule of 40 is most appropriately used in the technology – specifically software – industry but the principles of profitable growth are valid elsewhere.

The rule of 40 is used widely in the technology industry as a benchmark for firms looking to balance sales growth and profitability. Those that make the cut get rewarded with high valuations.

When trying to pick from the elite group, remember: firms that are able to balance a slowdown in sales growth with offsetting profitability improvements will generate the most cash, which is ultimately the most important thing for long-term investors.

The rule of 40 is most appropriately used in the technology – specifically software – industry but the principles of profitable growth are valid elsewhere.

Mentioned in story

As the cloud industry was exploding in the mid-2010s and software as a service (SaaS) firms were popping up everywhere, investors were grappling with how to assess a firm as it enters the inevitable aging process. Luckily, popular blogger Brad Feld created a simple performance measure that’s now widely used among investors and tech bosses alike: the rule of 40. Here’s how it can help you pick tech winners…

What’s the rule of 40?

It’s a simple enough idea: combined sales growth and profit margins should exceed 40% – no matter the age of the firm. Ideally, this should be over a multi-year period, not a one-hit-wonder-year. The rule implies that young tech firms motoring along at 40% or more sales growth needn’t worry about profit margins; they can wait. But when the gray hairs of age start to show, and sales growth slows, investors’ll want to see profit margins moving higher to compensate. And firms looking to live out their golden years on 10% or slower growth will need at least 30% in profit margins to retire fat and happy.

Whether Feld plucked 40% out of thin air only he knows, and it's by no means a binary thing where only firms hitting the hurdle do well and all others fail. But the rule’s been widely adopted by tech company bosses as an internal benchmark to hit, and there’s plenty of evidence to suggest it's important for investors too.

Take a look at the following chart, which is from a McKinsey study in 2021. The consultancy analyzed 100 publicly traded US SaaS companies with revenues of $100 million or more, all scoring at or above the rule of 40. The researchers used free cash flow margin (cash after all day-to-day expenses and large project outlays as a percentage of sales) for their profit measure. The results showed that the top 25 scoring firms traded at an average total enterprise value to revenues (EV/revenue) valuation of 22x. That’s almost twice the overall average and nearly three times the average valuation of the lowest-scoring 25 firms.

Source: McKinsey & Company.
Source: McKinsey & Company.

In short, the better a firm scored on Feld’s sales growth + profit margin measure, the higher the valuation investors were prepared to pay. What’s more, even the lowest-ranking members of the club commanded an 8x revenue valuation. That’s hardly a giveaway.

How can you use the rule of 40?

You can grab a firm’s five-year sales growth in the Markets tab of your Finimize app. For profit margin, the most widely used measure is earnings before interest, tax, depreciation and amortization (EBITDA) as a percentage of sales. You can usually dig this out of annual reports or from free investment tools like Koyfin.

Here’s the thing you want to remember when you’re peering through your rule-of-40 lens: when you really boil it down, only one thing matters in stock investing – cash. Without producing cash, companies can’t invest in themselves to grow, they can’t repay shareholders with dividends or buybacks, and ultimately they won’t survive.

And for companies to produce lots of cash over time, they must be able to grow and be profitable. One without the other doesn’t work. Sure, a firm can grow sales at 100% or more a year – and in the early days investors will be attracted to that – but if it never produces a dollar of profit, ultimately it's a worthless investment. On the flip side, profitability is great but without growth, cash flow production often stagnates. There’s only so much cost firms can cut to boost cash flow after all.

This leaves the middle ground of companies: those able to balance growth and profitability. It’s these firms that stand the best chance of producing the most cash over the years. It’s time for an example…

The chart below shows the annual profit from three made-up companies all conforming to the rule of 40. All our fictional firms start with $100 in sales. The supergrower (blue line) pulls in sales growth of 30% a year for 15 years with static 10% profit margins. Our graceful ager (red line) experiences step downs in sales growth every five years from 30% to 10%, but with offsetting margin increases from 10% to 30%. And our profitable plodder (yellow line) ticks along with 10% sales growth – not exactly pedestrian, we know: it’s still a member of the 40 club, after all – and 30% margins.

Source: Finimize.

Over the 15-year period, our supergrower churns out just under $2,200 of total profits and our plodder $1,100. Leading the pack, though, is the graceful ager. By trading gradual sales growth declines for margin increases, the firm manages to cross the line with total profits of $2,600.

Notice two other things in that chart. Firstly, the plodder falls way behind in terms of profit production. And secondly, our supergrower does catch up to the graceful ager eventually. But here’s the thing, very few – if any – firms can sustain 30% sales growth for 15 years. Usually, competition floods the market and takes a slice of the pie.

Which of today’s tech favorites make the cut?

Below is a selection of the largest US technology companies (including Tesla) that meet the rule of 40 criteria using a three-year average EBITDA margin and annualized (that's a smoothed average) sales growth over the past five years.

Source: Koyfin.
Source: Koyfin.

Mind you, picking stocks requires a more complete picture than what’s offered here, with just sales growth and profit margins. But if you’re thinking about investing in tech firms, this chart – and the rule of 40 – could serve as a starting point for your research. Just make sure you’re looking for the firms that can balance growth and profitability – they stand the best chance of producing the most cash over time. Happy hunting…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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