With so many tech stocks running hot, it's worth taking a look at the Rule of 40. The Rule of 40 is one way to analyze tech companies, especially SAAS (software as a service) companies, to check if their growth rate combined with their profitability is enough to warrant a premium valuation.
The Rule of 40 is calculated by adding the revenue growth rate and profit. The profit is usually calculated with Free Cash Flow Margin or EBITDA. When a company is in hyper-growth mode it's prudent to fund rapid growth and for the time being run at a deficit or a meager profit. However, it can be problematic if the company isn't growing fast enough, and doesn't have a sizeable profit yet either. The Rule of 40 can help us quickly measure this. The higher the number, the better. The rule of thumb is that a number higher than 40, meets this criteria.
Measuring Valuation
While the Rule of 40 is a useful tool to measure the growth vs profit, it doesn’t tell us anything about the current valuation. One other method is to check the PS Ratio (price to sales), if it is 5 times less than the Rule of 40 score, then it’s often considered a good value.
For an even better insight, you can divide the Rule of 40 score by the PS ratio. The higher the number, the better the growth and profit is relative to the price of the stock.
We ran a few examples using data from gurufocus. The below list is ranked by the highest Rule of 40/PS score. TWOU, ETSY, SE, MELI, CHGG appear to be the winners here.
Examples
| Symbol | PS Ratio | 1-Year Total Revenue Growth Rate | FCF Margin % | Rule of 40 | Rule of 40/PS |
|---|---|---|---|---|---|
| TWOU | 2.98 | 37.2 | -5.75 | 31.45 | 10.55 |
| ETSY | 15.28 | 84.2 | 36.76 | 120.96 | 7.92 |
| SE | 24.08 | 113.3 | 8.14 | 121.44 | 5.04 |
| MELI | 22.66 | 62 | 24.34 | 86.34 | 3.81 |
| CHGG | 16.78 | 48 | 13.75 | 61.75 | 3.68 |
| ESTC | 20.81 | 53.2 | -2.3 | 50.90 | 2.45 |
| ROKU | 22.3 | 55 | -2.08 | 52.92 | 2.37 |
| ZM | 103.49 | 190.4 | 52.34 | 242.74 | 2.35 |
| CRWD | 48.69 | 86.4 | 27.07 | 113.47 | 2.33 |
| TEAM | 32.46 | 30.9 | 31.58 | 62.48 | 1.92 |
| TWLO | 29.3 | 53.3 | -3.05 | 50.25 | 1.72 |
| WORK | 29.4 | 51.4 | -1.04 | 50.36 | 1.71 |
| SHOP | 49.58 | 75 | 7.46 | 82.46 | 1.66 |
| FVRR | 42.01 | 66.1 | 3.75 | 69.85 | 1.66 |
| DDOG | 56.15 | 73.6 | 14.35 | 87.95 | 1.57 |
| DOCU | 35.49 | 40.6 | 11.51 | 52.11 | 1.47 |
| OKTA | 41.22 | 44.6 | 9.09 | 53.69 | 1.30 |
| MDB | 30.88 | 45 | -8.64 | 36.36 | 1.18 |
| FSLY | 31.25 | 46.5 | -10.48 | 36.02 | 1.15 |
| PINS | 29.41 | 36.5 | -6.47 | 30.03 | 1.02 |
| TTD | 57.93 | 20.9 | 18.08 | 38.98 | 0.67 |
| NET | 57.56 | 50.5 | -23.69 | 26.81 | 0.47 |
| APPN | 45.4 | 15.7 | -7.38 | 8.32 | 0.18 |
| SPLK | 13.56 | 14.6 | -18.26 | -3.66 | -0.27 |
Valuation Course: An Introductory Course to Measuring the Value of Companies (Wiley Finance)
This site references only our opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice