Investor's Magic Formula - The Rule of 40

In investing and wealth management—especially when analyzing software and SaaS (Software-as-a-Service) companies—the Rule of 40 is a widely used benchmark to quickly assess a company’s financial health and its balance between growth and profitability.

What Is the Rule of 40?

The Rule of 40 states that a company’s revenue growth rate (%) plus its profit margin (%) (often EBITDA margin) should equal or exceed 40%. This threshold is seen as a sign of a healthy, sustainable business, especially in the SaaS and tech sectors.

Formula:

Rule of 40=Revenue Growth Rate (%)+Profit Margin (%)

Why Does It Matter?

• Investor Tool: Investors and analysts use the Rule of 40 to gauge whether a company is striking the right balance between expanding rapidly and generating profits.

• Growth vs. Profitability: High-growth companies might have low or negative profit margins, while mature companies may have slower growth but higher profitability. The Rule of 40 helps compare both types fairly.

• Investment Decisions: Companies meeting or exceeding 40% are viewed as attractive investments, and often command higher valuations. Falling below 40% can raise concerns about sustainability or efficiency.

Examples

• Company A:

  Revenue Growth: 35%

  EBITDA Margin: 5%

  Rule of 40: 35% + 5% = 40% (meets the rule)

  
  

• Company B:

  Revenue Growth: 15%

  EBITDA Margin: 30%

  Rule of 40: 15% + 30% = 45% (exceeds the rule)

  
  

• Interpretation:

  Both companies are considered healthy, but Company B’s stronger profit margin gives it a more balanced profile.

Key Considerations

• Not Absolute: The Rule of 40 is a guideline, not a guarantee. Context matters—startups may focus on growth, while mature firms may focus on profit.

• Industry Specific: Most relevant to SaaS and high-growth tech companies, where balancing rapid expansion with profitability is critical.

• Investor Preferences: Some investors may accept lower profitability for higher growth (and vice versa), but the Rule of 40 provides a quick, apples-to-apples comparison.

In summary

The Rule of 40 is a simple, effective metric for evaluating whether a SaaS or tech company is achieving a healthy balance between growing its revenues and generating profits. Companies that meet or exceed the 40% threshold are generally seen as well-positioned for long-term success in the eyes of investors and wealth managers.

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Related blogs:

1. https://www.wealthycanadian101.com/post/5-biggest-investment-mistakes-to-avoid

2. https://www.wealthycanadian101.com/post/world-financial-planning-day-empowering-your-financial-future-1

3. https://www.wealthycanadian101.com/post/2025-official-figures-released-by-the-canada-revenue-agency-cra