The ‘Rule of 40’ is increasingly being adopted by high growth company executives as an important metric to help measure the trade-offs of balancing growth and profitability.

Most retail investors may be unfamiliar with the term yet it is simple to understand and easy to apply. It can help you decide whether to back a high growth story or avoid it like the plague.

The premise was originally used by venture capitalists as a way to assess software start-ups, particularly those that were growing fast but running up huge losses. It is today regularly used to assess any fast-growing digital economy company, and there’s no obvious reason why it cannot be applied more widely.

The Rule of 40, or R40, is the principle that a company’s combined sales growth rate and profit margin should be at least 40%, and ideally better. Investors using this metric therefore consider a company with an R40 score of 40 or more to be a good investment opportunity and a figure below 40 to not be of interest.

The metric neatly captures the fundamental trade-off between investing for future growth – such as developing new products and acquiring new customers – and short-term profitability.

To give you an example, Apple is the world’s biggest company by market value and is very profitable. It commanded EBITDA (earnings before interest, tax, depreciation and amortisation) margins of 29.4% in the financial year to 30 September 2019. But sales fell by 2% last year. If you add those figures together you get a R40 figure of 27.4 which is below the 40 benchmark.

Different analysts tend to have varied views on which measure of profitability is best to use. Some have proposed free cash flow; others see earnings before interest and tax (EBIT) or net income as better alternatives.

But most tend to favour EBITDA, a profit metric widely used by fast growing software-type companies that strips out the cost of capital investment.

WHAT IF THE COMPANY IS  LOSS-MAKING?

When there are losses instead of profit, you subtract the margin percentage from the revenue growth rate.

For instance, transport group Uber is supposed to be growing very fast. The main reason people buy the stock is that they believe it can continue to expand its markets and customers in the coming years to emerge as a virtual monopoly player in its space. Theoretically that would give it immense pricing power and that’s when huge profit and cash flow could start flowing from the business into shareholder’s pockets.

Only that’s not happening. The latest quarterly results show a trend that Uber’s sales growth is slowing down. For the three months to 30 September growth was 20.4% (quarter-on-quarter); the previous quarter was 13% but just under 20% in the January to March period. That compares with 43.3% in 2018, which itself was down on the 106% in 2017.

In the most recent three month period, Uber made $3.813bn sales and $585m EBITDA losses which equates to a negative 15.3% margin.

Interestingly, this has translated directly into share price performance, with Uber’s stock down 40% to $26.98 since the company went public in May.

We’ve used the quarter-on-quarter figures to get a sense of the current trend. You may want to use full-year figures (and year-on-year) for companies with seasonality such as tour operators that lose money in one half of the year and make all the profit in the rest of the 12  month period.

IS IT COMMON TO SCORE MORE THAN 40?

R40 becomes useful in tracking the progress of a fast growing business as it expands, matures and becomes more focused on profit, cash flow and  shareholder returns.

But consistently strong performance against the R40 is difficult to maintain. Consultant Bain & Company found that 40% of S&P 500 software companies achieved an R40 score above 40 in a single year (2017).

Of 86 companies researched from 2013 to 2017, just 25% outperformed the R40 for three or more years, and only 16% outperformed for all five years, adjusted for mergers and acquisitions.

Redpoint venture capitalist Tomasz Tunguz says the rule of 40% might be a good filter for investors in later stage companies to identify outliers, or relatively rare businesses capable of producing a sustainable mix of growth and profit into maturity.

‘The spirit of the R40 is a good one’, he states. ‘It establishes a relationship between the growth rate and burn rate of a business and defines a healthy operating zone for a growth stage business.

‘Consequently, the R40 metric may be a solid first pass filter for a growth equity investor to determine whether a business might be a good investment candidate.’

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