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With almost 200 pure-play public software companies operating in the United States, picking the best stocks could be challenging. On the one hand, small companies growing quickly like Datadog are barely profitable, while other large and well-established firms like Microsoft generate billions in cash but with slower growth.
Choosing between these two types of companies could feel like an apples-to-oranges comparison without an elegant solution. Empowered with the right financial indicator, that can be much easier. In this article, we'll discuss how to use the Rule Of 40 to spot winning software companies.
What Is The Rule Of 40?
Based on the Rule Of 40, a healthy SaaS company's recurring revenue growth rate plus EBITDA margin should be equal to or greater than 40%. It is a straightforward way of evaluating SaaS companies made famous by Brad Feld, a leading VC investor and founder of Techstars.
As you can read in this article from LBS, once a tech company achieves market dominance, mutually reinforcing factors make it almost impossible to displace. Since SaaS companies usually operate in winner-takes-all markets, they can even lose money as long as they grow fast enough to achieve that so much important monopoly.
As this research from Bain & Company shows, growth falls off over time, and businesses need to achieve better profitability to meet the Rule Of 40 once they become larger and well-established firms.
How To Calculate The Rule Of 40: Formula Explained
As mentioned above, the Rule Of 40 requires a healthy SaaS company's recurring revenue growth rate plus EBITDA margin to be equal to or greater than 40%. So the Rule Of 40 formula is:
MRR YoY Growth + EBITDA Margin > 40%
Let's break down the individual components of the formula:
- MRR YoY Growth: Monthly Recurring Revenue (MRR) is one of the most important metrics for subscription and SaaS companies. It represents the amount of recurring revenue a business expects monthly.
- EBITDA Margin: A profitability metric which is equal to EBITDA to Revenue. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
Jim Cramer's Rule Of 40: Taking Valuation Into Account
As Jim Cramer explains over on Mad Money, it doesn't matter how much a business is growing or how profitable it is because if the stock is too expensive, you may still end up losing money. So the problem with the Rule Of 40 is that it doesn't take into account valuation.
That's why he suggests using the following modified version of the formula:
According to Jim Cramer's Rule Of 40, a company's revenue growth plus its EBITDA margin should be at least five times the size of its price to sales multiple.
Rule Of 40 Calculator
You can calculate the Rule Of 40 for every single company in the world using this template. You just have to enter the required data of the company whose ratio you want to calculate, and the model will do everything automatically. You can use the Finbox Data Explorer to get all the data you need for 100,000+ companies worldwide.
Here's a preview of Finbox's Rule Of 40 Calculator:
Can You Beat The Market Using The Rule Of 40?
Would you have been able to beat the market if you had applied the Rule Of 40 since the beginning of this millennium? What about Jim Cramer's modified version? We ran a quick backtest to find out!
Rule Of 40 Backtest
Jim Cramer's Rule Of 40 Backtest
Note: We include only stocks with a market capitalization greater than $300M for liquidity and data quality problems.
Takeaways
Since SaaS companies usually operate in winner-takes-all markets, growing fast is extremely important for the network effect to occur and achieve a monopoly in their market.
That makes it difficult for investors to choose between small but fast-growing companies and well-established firms with better profitability and slower growth. The Rule Of 40 is a straightforward way of evaluating and spot winning software companies.
