How this number is made
The rule of 40 adds the percent growth of revenue to the percent profit margin and asks whether the sum clears 40. It is a heuristic investors use for software companies. It is not a valuation, and a business can clear it in a way that is still a bad business.
- Growth and margin should be the same period, usually a year.
- Say which profit you used. Free cash flow and EBITDA give different scores.
Formula
Score = revenue growth percent + profit margin percent.
Worked example
With the figures already in the form, growth plus margin is 35.0.
Questions
Does clearing 40 mean the company is healthy?
It means growth and profitability, added, cleared a line someone drew. Cash can still be tight. The line is a screen.
Which margin?
Whichever you announce. Do not mix a gross margin with a peer’s free-cash-flow margin.