By Jonathan Weil
Like hemlines and haircuts, stocks go in and out of fashion. So do the ways companies communicate their performance to investors. Whatever numbers investors want to see, management will supply them, especially if they can be easily tailored to look flattering.
For so-called SaaS companies, selling software as a service, a favorite metric nowadays is something called the "Rule of 40." The first thing to know is it isn't a rule, because there is no standard definition for what it means. For some companies it has become a big deal to claim membership in the "Rule of 40 club" nonetheless.
In general the rule holds that a company's revenue growth plus its profit margin should be 40% or greater. So if a company has 20% revenue growth and a 20% margin, it gets to be in the club. Same for 40% growth and no margin, or 30% growth and a 10% margin.
Brad Feld, a venture-capital investor, popularized this notion with a blog post back in 2015 called " The Rule of 40% For a Healthy SaaS Company." The term's first appearance in a company's Securities and Exchange Commission filing was in 2017, going by the results of a database search on the SEC's website. A 2021 study by McKinsey, the consulting giant, is credited for helping spread its usage and showed that the market rewarded companies with higher valuations if they are at or above the Rule of 40.
Here is where it starts to fall apart: While revenue has a standard meaning, there is no consensus on which measure of profit companies should use to calculate the margin component. Should it be operating income? Net income? Cash flow? Maybe some nonstandard version of earnings or cash flow? The numbers that companies are showing lack comparability because they aren't apples-to-apples, and the companies often don't show their math.
But say everyone could agree on a particular margin metric to use for the calculation. The traditional one that McKinsey recommended was free cash flow. This typically is defined as operating cash flow, which has a standard definition, minus capital expenditures. Even then, the metric's usefulness starts to crumble. Done this way, the rule favors companies that rely heavily on stock-based compensation to pay their employees, while punishing those that don't and instead pay more heavily in cash. That is because free cash flow, like operating cash flow, excludes stock-based pay, which is a real cost that counts in companies' reported profits.
David Zion, founder of Zion Research Group and a longtime accounting and tax analyst, in a December research note did his own Rule of 40 calculations for North American application-software companies with stock-market values of greater than $1 billion. For this exercise, he took the sum of revenue growth plus free-cash-flow margin using the last reported four quarters. Of the 98 companies in the group, 33 of them met or beat the Rule of 40. However, when he adjusted free cash flow to treat stock-based pay as an expense, only 11 companies still met or beat the Rule of 40 under both methods. They included Palantir Technologies and Constellation Software.
At Freshworks, for instance, during the company's recent earnings call, Chief Executive Dennis Woodside said, "adding our revenue growth and free-cash-flow margin for Q3, we exceeded the Rule of 40 in the quarter." Indeed, Zion calculated that its Rule of 40 number was 41%, which put Freshworks at No. 29 on his ranking out of the 98 companies. Revenue growth was just over 20%, and so was free-cash-flow margin.
But when Zion adjusted Freshworks' margin figure to treat stock-based pay as an expense, its Rule of 40 number fell to 9% and its ranking dropped to No. 76. The reason: Its stock-based pay exceeded its free cash flow. In other words, if that compensation had been paid in cash instead of stock, Freshworks' free cash flow would have been negative, and its free-cash-flow margin would have been negative 11%.
Similarly, Workday's chief executive, Carl Eschenbach, at an investor conference in May said "we're a Rule of 40 company." Using free-cash-flow margin for the calculation, Zion showed its Rule of 40 number was 44% for the past four quarters, but it was 26% if stock-based compensation was treated as an expense.
The reason that any of this matters, Zion says, is that the market has been rewarding companies with higher valuation multiples if they are at or above 40%, as McKinsey found in its study. However, it appears the market may not be distinguishing consistently between higher quality and lower quality Rule of 40 numbers.
"A big drop in the rankings for a company indicates to us that its Rule of 40 ranking is driven more by financial engineering (how employee compensation is financed) than its peers," Zion wrote in his note. Thus a big question for investors, he said, is, "How much are you willing to pay for a Rule of 40 company that is primarily there because of how they've decided to finance their employees' compensation?"
Better yet, until there is some consensus on how to do this number, just 86 the rule.
Write to Jonathan Weil at jonathan.weil@wsj.com
(END) Dow Jones Newswires
January 03, 2025 06:00 ET (11:00 GMT)
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