For the Magnificent Seven technology companies, the AI revolution is like rocket fuel. stock And its popularity has reached astronomical heights. So it’s not really surprising that people are whispering about a bubble and wondering if the stock price has gone too far. That’s why it’s a good time to assess risk using popular blogger Brad Feld’s simple performance metrics, the Rule of 40.
What is the rule of 40?
It’s a very simple idea. It’s a combination. sale growth and profit margin Regardless of the age of the company, it must exceed 40%. Ideally, this should be spread out over multiple years, rather than a one-hit wonder year. This rule means that young technology companies with revenue growth of 40% or more don’t have to worry about profit margins and can wait. However, as gray hair begins to show due to aging and sales growth slows, investors begin to desire higher profit margins to compensate. And a company that wants to live out its golden years with a growth rate of less than 10% will need a profit margin of at least 30% to retire fat and happy.
Only he knows whether Mr. Feld squeezed 40% out of thin air, and this is by no means a binary theory in which only companies that reach a hurdle will succeed and all others will fail. But the rule is widely used by tech company executives as an internal benchmark, and there’s a lot of evidence that it’s important to investors as well.
Look at the following graph. This is according to a 2021 McKinsey study. The consultancy analyzed 100 publicly traded SaaS companies in the United States. income The researchers used free cash flow margin (the percentage of cash left after all day-to-day expenses and large project expenditures) as a measure of profit. The results showed that the top 25 companies were trading at an average valuation of 22 times total enterprise value and earnings (EV/Revenue). This is nearly twice the overall average and nearly three times the average valuation of the 25 lowest-scoring companies.
Source: McKinsey & Company.
In short, the higher a company scores on Feld, the more sale growth+ profit margin The higher the valuation, the more investors are prepared to pay. What’s more, even the lowest-ranking member of the club achieved a high score of 8x. revenue evaluation.
How can you use the Rule of 40?
Understand a company’s five-year sales growth and profitability from annual reports and free investment tools like Koyfin. The most widely used measure of margin is pre-profit. interesttaxes, depreciation, and amortization (EBITDA) as a percentage of sales.
Here’s what to remember when looking through a 40-degree lens: When it comes down to it, only one thing matters. stock Investment – cash. If a company does not generate cash, it will not be able to invest in itself to grow, nor will it be able to repay shareholders through dividends or stock buybacks, and ultimately will not survive.
And for a company to generate more cash over the long term, it needs to be able to grow and become profitable. One cannot function without the other. Indeed, companies can increase sales by more than 100% annually. And in the early stages, investors will be attracted to it. But if you don’t generate even a single dollar of profit, your investment will ultimately be worthless. On the one hand, profitability is great, but without growth, cash flow production often stagnates. After all, there are limits to how much costs companies can cut to increase cash flow.
That leaves middle-tier companies that can balance growth and profitability. These companies are the ones most likely to generate the most cash over the years. It’s time for an example…
The graph below shows the annual profits of three hypothetical companies that all follow the Rule of 40. All fictitious companies start with sales of $100. This super grower (blue line) has achieved 30% annual sales growth over 15 years while maintaining a 10% profit margin. In our graceful age (red line), sales growth declines from 30% to 10% every five years, but offsets this by an increase in margins from 10% to 30%. And our profitability is trending well (yellow line) with 10% sales growth, which is no mean feat. After all, the company is still a member of the 40 club and has a 30% margin.
Over 15 years, our super grower will produce a total of just under $2,200. profit And our walk is $1,100. But leading the way is the graceful Ager. By gradually trading sale growth decreases margin As profits increased, the company managed to cross the $2,600 gross profit threshold.
Notice that there are two other points on this graph. First, plodder lags far behind in terms of profit production. And secondly, our super growers will eventually catch up with our graceful ageers. But the problem is that very few, if any, companies can sustain 30% revenue growth for 15 years. Competition usually rushes into the market and takes away a piece of the pie.
Who of the Magnificent Seven will be chosen?
Below are the most popular ones stock The Magnificent Seven is currently riding the top of the AI wave in the world. The graph below shows the distribution of the three-year average. EBITDA Profit margin and average sales growth over the past five years.
Source: Finimize, Koyfin.
Perhaps unsurprisingly, these are generally fast-growing and highly profitable companies. But two things stand out. First, Amazon: If you add this: sale 20% growth EBITDA margin 13% would be 33%, well below the all-important 40. And then there’s Apple. 9% revenue growth and 33% EBITDA margin puts Apple at 43%. Yes, I’m over 40, but not by much. Given that other companies are far ahead (Alphabet 51st, Meta 63rd, Microsoft 64th, Nvidia 88th, Tesla 54th), the Magnificent Seven’s technology holdings can be compared to the latecomers 2. It would be wise to rebalance it away from the company and towards the leader.
And yeah, I’m choosing stock A more complete picture is needed than the one provided here, but sales growth and profit margin. But if you’re thinking about investing in high-tech companies, this chart and the Rule of 40 are a good starting point for your research. Be sure to look for companies that can balance growth and profitability. These are the companies most likely to generate the most cash in the long run. Happy hunting…
