Growth investors use the rule of 40 as a screening tool to quickly assess companies while balancing the growth rate and profit margins. The idea of the rule is that the growth rate plus the profit margin should meet or exceed 40%. Growth usually comes at the expense of profit. A company can have 40% growth and 0% profit margin, or 20% growth and 20% profit margin or 0% growth and 40% profit margin and still be in this exclusive club.
Beating the rule of 40 in a single year is admirable, but the greater challenge is balancing growth and performance year after year while maintaining financial discipline (i.e., keeping debt under control).
The rule of 40 can also help identify compounders. I will demonstrate the process with a few examples.
Apple
First up is Apple Inc. (AAPL, Financial).
Apple's net profit margin in 2021 was 25.88%, while its revenue growth was 33.26%. Adding these two numbers gives us 59.1%. So the tech giant met the hurdle of 40 in 2021.
Instead of revenue, we can do the same thing with Ebitda growth. Apple's Ebitda growth was 51.98% and the net margin plus Ebitda growth is 77.86%, so it handily beat the rule in 2021 on both metrics.
Using both revenue and Ebitda gives us a different sense of growth. We can, of course, use growth metrics as well, such as operating earnings growth or even net earnings growth. However, going lower on the income statement can given more false negatives.
A quick way of checking if a number has met the criteria is to divide the number by 40 (the hurdle). If the quotient obtained is 1 or above, then it is a pass. If not, then it is a fail. The following charts show the rule of 40 quotient over time as a blue bar. The red line is the hurdle.
However, looking back over the past nine years, Apple passed the rule of 40 twice, which is OK but not great.
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Adobe
Now look at another tech software stalwart, Adobe Inc. (ADBE, Financial). The company met the criteria six and seven times in the past nine years.
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So using the growth and profitability criteria, Adobe may have better potential and is a more consistent performer.
Nvidia
Another company which has consistently met the rule of 40 is chipmaker Nvidia Corp. (NVDA, Financial). The company passed the threshold five and six times out of nine.
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Taiwan Semiconductor
Taiwan Semiconductor Manufacturing Co. Ltd. (TSM, Financial) is another star, meeting the criteria in seven out of nine years for both methods. The chipmaker's stock is also significantly undervalued.
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T. Rowe Price
For both methods, T. Rowe Price Group Inc. (TROW, Financial) hurdled over the minimum mark seven times in nine years. The investment management company is also considered significantly undervalued based on GF Value criteria.
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Intel
In contrast, Intel Corp. (INTC, Financial) only passed the threshold one and two times over the nine-year period. Therefore, the semiconductor company may not be a good choice for growth-oriented investors.
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Conclusion
The rule of 40 is a great tool to find companies with consistent profitability and growth. The current bear market has presented investors with a target-rich environment to capture consistent compounders that were too expensive a year ago. Some of the companies discussed that consistently pass the rule of 40 are currently undervalued compared to their potential.
Of course, investors should conduct their own due diligence to determine if these ideas are suitable for their portfolios.
