Software as a service (or SaaS) companies are organizations that use software to provide customers with a service. Since many of these companies are at an early stage, their form of analysis varies with respect to consolidated stocks with dividends.
Do you prefer the revenue growth of Salesforce or do you value the balance of Adobe?
The Rule of 40 is a common metric used by private equity investors and strategic buyers to measure the performance of SaaS companies. Measuring the trade-off between profitability and growth, the Rule of 40 asserts that a successful SaaS company’s growth rate and profit margin should add up to 40% or more.
The Rule of 40 Creates a metric that measures the balance between growth and profitability, and by extension, the sustainability of the business more broadly.
STEP I – REVENUE GROWTH
If the software company you are analyzing is relatively small or new, it is likely that revenue growth will be achieved more easily than for a big company. It is probably more easy to have a 40% growth revenue rate if you sell $100 Mill than if you are a monster selling in the orders of Billions. Because it is likely that you will analyze new companies, we usually use quarterly data instead of annual data to calculate revenue growth rates.
STEP II – PROFITABILITY MARGIN
There are many measures of profitability using EBIT, EBITDA, Operational Data and others. Our focus on DATATISTIC is to use Free Cash Flow as the main input to analyze the profitability of a company. We said it is more likely to have larger revenue growth rates at an early stage. It is probably easier to watch profitable companies that have been in the market for a while with a validated product.
STEP 3 – CALCULATE
In the end you would like to have a company that provides both, momentum and margins. So, for each stock that you analyze, you sum their revenue growth rate and their free cash flow margin in order to have a measure that allows you as an investor to compare new entrants in the market with stablished ones.
We will provide a basic example of 4 software companies Rule of 40 calculations. But keep in mind that the true power of this analysis comes up when you analyze the whole Software ecosystem in a dispersion chart to verify which are the true market leaders and which companies are giving red alerts.
These are the results from 2 European and 2 American software companies. Unity despite having the largest revenue growth from the 4 stocks, lack profitability (negative at the moment), which in turns give them a 33% Rule of 40 which is a clear Fail on this metric. SAP, a traditional European company has decent profitability margins but lacks revenue growth. From this 4, it seems like Palo Alto Networks offers a good profitable business model while attaching also decent revenue growth measures.
As we said before, the power of this tool magnifies when mapping the ecosystem of software stocks in a single graph that also takes into account the size of the companies. If you want to see which are the leading stocks and which are lagging, subscribe to our Patreon here and get the best market analysis, stock recommendations and much more.