Venture capitalists have a simple method for determining whether to invest in a young SaaS start-up or to pass on the opportunity. Dubbed the Rule of 40, this calculation is a way of measuring revenue and profit growth in software companies (even if there are no profits yet). The math is easy. You take the annual revenue growth of a company as a percentage (say, 50% revenue growth) and add to that number the profit margin of the company (for instance, 10%). In this example, the hypothetical company would have a Rule of 40 score of 60, which is outstanding. A score of 40 or above constitutes a pass, while a score below 40 means the company fails the Rule of 40 test.
This model is very helpful for containing our exuberance. Growth investors have a tendency to get very excited when seeing impressive top-line growth. "Company X is growing at 100% a year. Wow!" And since growth investors are used to investing in unprofitable companies, it's easy to ignore the bottom line. That's a mistake. After all, some negative profit margins are far worse than others.
On the flip side, value investors are thrilled by companies with high margins. "A profit margin of 35%. Amazing!" But they can fail to pay attention to whether revenue growth has stalled. The Rule of 40 is not only a handy model for young start-ups; it's also helpful to apply to companies on the downside of the growth cycle, so investors know if there is any upside to be had.
Of course, the model was introduced to measure young, unproven companies, and that's where it really shines. Consider Datadog (NASDAQ:DDOG), a cloud analytics company that IPO'd last week. Datadog reported an outstanding 82% revenue growth, compared to the same period last year. That's an amazing number. And its profit margin was negative 9.29%. While a negative profit margin is bad news, we can forgive it in this case because the loss is so slight, and the company's revenue growth is so high. Adding the numbers together, Datadog has a Rule of 40 score of 73. That's fantastic. One can feel comfortable investing in Datadog, assuming the price is right, because the underlying business is so strong.
Now contrast Slack Technologies (NYSE:WORK), a cloud company with a collaborative software product. It had quarterly revenue growth of 57%, compared to the same period a year ago. That is very strong. A lot of growth investors see numbers like that and start to get excited. But wait a second. Its profit margin is negative 94%. Ouch! Now Slack has a negative Rule of 40 score of 37. That's not a good score at all. Anything below 40 is sub-optimal. But when your result is actually negative, that's a warning sign.
I got a lot of surprising insights by applying the Rule of 40 to my family's portfolio. Since the Rule of 40 is so simple to use, I applied it to every stock we own, not just software companies. The results were very interesting.
Our top ten holdings are Apple (NASDAQ:AAPL), Shopify (NYSE:SHOP), Intuitive Surgical (NASDAQ:ISRG), The Trade Desk (NASDAQ:TTD), Carvana (NYSE:CVNA), Visa (NYSE:V), Square (NYSE:SQ), Ionis Pharma (NASDAQ:IONS), Roku (NASDAQ:ROKU), and Amarin (NASDAQ:AMRN). Several of these companies are not cloud stocks and are not typically subject to the Rule of 40. But just to see what happened, I quickly tried it. Here are the numbers:
|Company||Rev. Growth (y-o-y)||Profit Margin||Rule of 40 Score||YTD % Stock Return|
|Intuitive Surgical||21%||30%||51 (PASS)||11|
|The Trade Desk||42%||17%||59 (PASS)||78|
|Ionis Pharma||39%||50%||89 (PASS)||16|
After analyzing my own portfolio, I applied the rule to a lot of other companies, too. I discovered that Innovative Industrial Properties (NYSE:IIPR), a REIT focused on the cannabis space, scored an astronomical 207 on the Rule of 40 test. If a score of 40 represents a great company, 207 is five times greater than great. Innovative Industrial Properties is an expensive stock (its P/S ratio is 44); now you know why. Other companies with sky-high Rule of 40 scores include Shockwave Medical (NASDAQ:SWAV), Guardant Health (NASDAQ:GH), and StoneCo (NASDAQ:STNE), with scores of 166, 118, and 117, respectively.
I ran a Rule of 40 calculation on 100 stocks, and discovered that 42 of them had a score higher than 40. And the average market return of those 42 stocks in 2019? The stocks are up an average of 49% so far this year. And sure enough, companies that scored under 40 had weaker returns. The 58 companies that failed the Rule of 40 had an average return of 25%. Not bad, but definitely worse than the high-flyers. And the companies that had a Rule of 40 number below zero did the worst of all: The negative companies had an 11% stock return on average, underperforming the market.
Perhaps the best part of the Rule of 40 is that it can keep high-growth investors from buying those dangerous stocks that can sink your portfolio. For instance, Uber (NYSE:UBER) is supposed to be a high-growth name. And yet its numbers show that Uber's growth last quarter was an anemic 14%. And its profit margin is still awful: a negative 66%, for an ugly Rule of 40 score of negative 52. Not surprisingly, when your Rule of 40 number is below zero, the stock is often punished. Uber's stock has dropped 30% since the company went public in May.
Another example is Jumia (NYSE:JMIA), the internet retailer of Africa. Jumia's revenue growth is 58%, which is strong. But that result is overwhelmed by the company's ugly bottom line, a profit margin of negative 140%. With its Rule of 40 score being negative 82, investors ought to avoid this stock for now. Indeed, Jumia has lost 63% of its value since the company went public last April.
You should apply the Rule of 40 to any stock before you buy it. Adding revenue growth and profit margin together gives investors a quick and decisive way to measure the health of a company. And it's the strong companies that will give the strongest returns to investors over time.