The Rule of 40 Revisited

The Rule of 40 is a widely used heuristic in the software industry that became wildly popular during the last 10 years. It is worth revisiting because it can help companies to balance their ambitions for revenue growth and efficiency.

It says that companies with a combined profitability and growth of more than 40% can achieve much higher valuation levels than companies that don’t. In our analysis, we measure profitability as the Operating Cashflow Margin (TTM) and add the expected revenue growth for 2025.

We analyzed listed software companies headquartered in Germany and Austria, along with U.S. software companies with a market cap exceeding $1B. The sample’s median EV/Sales is 6.1x, and the median Rule of 40 metric is 35%. The 41 companies that achieve >40% command an EV/Sales multiple of 8.6x, compared to 3.8x for the 70 companies below 40%.

While the R² for the Rule of 40’s correlation with EV/Sales has ranged between 0.5 and 0.6 in 2020 / 2021, it currently stands at 0.4. The explanatory power of the metric is meaningful, though there are other variables influencing valuations.

During periods of market exuberance, investors prioritize growth over profitability. For instance, Bessemer determined a relative importance of 6:1 in November 2021. In contrast, during crises, the emphasis shifts towards profitability, though the balance rarely exceeds a 1:1 ratio. This is due to the compounding effect that growth can have on profitability if companies have operational leverage.

The Rule of 40 remains a straightforward yet robust predictor for valuations, offering key implications for strategy and target setting:
I) Software companies should carefully balance growth and efficiency, neglecting either one destroys value no matter which stage the company is in
II) Growth of 10% annually is the bare minimum to command EV/Sales multiples beyond 10x, the target should be in the 15% to 20% range
III) As companies mature, M&A becomes a crucial pillar of strategy to sustain this kind of growth

As always, feel free to reach out to discuss how the Rule of 40 can inform your company’s strategy or valuation goals.