More often than not, investors see a trade-off between profitability and growth, especially when it comes to software companies. Rapid business expansions usually come at the cost of short-term profits, and a quantifiable balance is better required to create lasting shareholder value. This is where the Rule of 40 plays its role.
The rule, which compares the sum of the growth rate and percentage of margin against a passing score of 40, originated among venture capitalists to gauge the healthiness of young software-as-a-service (referred to as “SaaS”) start-ups. Since then, it has become broadly employed to measure larger software companies, including publicly-traded ones.
According to Bain & Company, 40% of the selected software companies outperformed the Rule of 40 in 2017, but only 25% and 16% of them had outperformed for all the past three years and five years, respectively, implying that consistently strong performance against the rule is a challenge. The consulting firm categorizes these outperformers into three groups – the vigorous grower, the balanced profitable grower and the profit seeker.
Over the long haul, we believe that it would be much easier for growth rates to decay to the average level than for margins. Plus, it can be evidently difficult to revive any growth that has once slowed down. To maintain a high growth or super-normal profitability, an economic moat is crucial and necessary, reflected by the pricing power, cost advantage and high switching cost of the business model.
Below, we put together a quick list of moaty software companies that have beaten the Rule of 40 over the last three years. We calculate the score based on the average free cash flow margin and average revenue growth rate.
The Washington-based technology conglomerate develops, manufactures, licenses, supports and sells computer software, consumer electronics, personal computers and related services, including its best-known products, such as Windows, Office and Xbox. Its free cash flow margin and annual top-line growth averaged 31.5% and 14.05%, respectively, for the last three years, indicating a Rule-of-40 score of 46.
Oklahoma-based Paycom Software is an American online payroll and human resource technology provider that helps businesses to manage the complete employment lifecycle, from recruitment to retirement. Over the past three years, the free cash flow margin and annual top-line growth of the business averaged 18.77% and 30.94%, respectively, earning the company a Rule-of-40 score of 50.
California-based Adobe Systems is the software leader in multimedia and creativity products, including the well-known Adobe Flash, Photoshop, Illustrator and Acrobat Reader. For the last three years, its free cash flow margin and annual top-line growth averaged 38.39% and 24.03%, respectively, indicating a robust Rule-of-40 score of 62.
LiveChat Software (WAR:LVC, Financial)
Poland-based LiveChat Software is a customer service technology company that develops SaaS-based help desk software and online chat software for e-commerce sales, customer support,and lead generation. The company serves over 28,000 paid customers in more than 150 countries, including Adobe, AirAsia, Best Buy, ING, Huawei and Paypal. Its free cash flow margin and annual top-line growth averaged 48.53% and 27.76% respectively over the past three years, earning the company a superb Rule-of-40 score of 76.
Tobila Systems (TSE:4441, Financial)
Japan-based Tobila Systems designs phone call-filtering systems, information processing platforms and other mobile related products. With an average free cash flow margin of 23.94% and annual top-line growth of 29.42% for the past three years, the company delivers a Rule-of-40 score of 53.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any security mentioned in the article.
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