Rule of 40 Explanation

The Rule of 40 is a key figure that is derived from various fundamentals and thus provides a first impression of a stock. Here, the growth rate (in %) and the profit margin (in %) are added together. If the sum equals 40, this indicates a strongly growing and profitable company.

The Rule of 40 originates from the Silicon Valley and is used there as a key indicator for technology companies. It was developed by venture capitalists to measure the success of small, rapidly growing companies in a simple manner. Because this rule takes into account the two most important things:

The two questions are very important in context because growth is easy to achieve. Generating profitability is, however, a bit more difficult. An example of this is companies that offer starting capital or welcome gifts. Here, one often finds high growth but little opportunity to turn the entire model into a positive result.

How is the Rule of 40 calculated?

As mentioned above, the Rule of 40 consists of revenue growth and profit margin. Assuming a company has an annual revenue growth of 25% and a profit margin of 20%, then the sum of both values would be 45%. In this case, the value would be above 40% and the company is therefore "attractive" for a closer look.

Examples

Many fast growers have already achieved revenue growth of over 40% alone. Good examples are Amazon or Cloudflare. However, these companies have a relatively low profit margin, which means that a way must be found in the long run to generate a higher profit margin.