The Rule of 40: A Quick Guide for Evaluating Growth Companies
The Rule of 40 is a popular framework for evaluating growth-stage companies. It combines revenue growth rate and a profitability metric to measure business sustainability. On this site EBITDA margin is used as the profitability component. The formula is simple: revenue growth rate plus EBITDA margin should total at least 40%.
Using EBITDA margin has distinct advantages. EBITDA (earnings before interest, taxes, depreciation, and amortization) focuses on a company’s operating performance. It excludes non-operational expenses, making it a better indicator of core profitability. For growth companies, where net profits might be negative, EBITDA margin provides a clearer picture of operational efficiency.
This approach balances growth and financial health. Companies surpassing 40% demonstrate strong growth while maintaining efficient cost structures. It also adjusts for industry variations, making it useful for businesses like SaaS companies, where EBITDA is often a key benchmark. In historical analysis of successful SaaS companies, a combined score of 40% was seen as a common characteristic of well-performing businesses.
However, EBITDA margin has its limitations. It ignores capital expenditures, debt repayments, and working capital changes. A high EBITDA margin might not translate to strong cash flows or long-term viability. Relying solely on the Rule of 40 could overlook critical financial pressures or misrepresent sustainability.
The Rule of 40, using EBITDA margin, is a valuable tool for investors and analysts. It highlights the trade-off between growth and operational efficiency. Still, it should be part of a broader assessment, incorporating cash flow and balance sheet health for a complete picture.
An Example
I ran a quick filter over the almost 500 companies that I follow and this was the result:
This is the “Who’s Who” of the best performing companies on the ASX (and a couple of US stocks). Only 3 companies failed to increase in price this year but all of those (except IFM) are coming off a great year last-year.
This was the criteria that I used:
- Rule of 40 value greater than 40
- Net Debt / Equity % less than 1 (this means companies with low to no debt)
- Exclude sectors Property, Utilities, Basic Materials and Consumer Cyclicals.
The latest list of Rule Of 40 Stocks can be viewed HERE.
Disclaimer: This information is provided purely for educational purposes. It takes no account of an individual’s personal financial circumstances and hence can in no way constitute financial advice. The above data may be subject to errors or inconsistencies for which the author takes no liability. It is imperative that all investors do their own research or if they need advice, seek it from a qualified financial adviser.
What is the Rule of 40?