Rule of 40

The Rule of 40 is a rough heuristic used to judge software and other subscription businesses, checking whether a company's revenue growth rate plus its profit margin add up to at least 40%. It's a quick way to weigh growth against profitability together, rather than judging either one on its own.

The formula is:

The margin used is usually a profitability measure like EBITDA margin or free cash flow margin rather than net margin, since many growth-stage software companies aren't consistently profitable on a net income basis. The logic behind the rule is that a fast-growing company is allowed to sacrifice near-term profitability in exchange for growth, and a slower-growing company should be compensating with stronger margins, but the sum of the two should still clear a reasonable bar. A company growing revenue 50% a year with a negative 20% margin scores 30 and falls short. A company growing 15% a year with a 30% margin scores 45 and clears it comfortably.

The Rule of 40 is a screening tool, not a precise valuation method, and it was built around software companies specifically, so it doesn't translate well to industries with fundamentally different growth and margin dynamics. It's most useful as a quick gut check on whether a company is balancing growth and profitability reasonably, or leaning too far toward one at the expense of the other, before digging into the underlying numbers in more detail.