Investing

Rule of 40: A Model for Investing in Public SaaS Companies

Just a few years ago, many people were bemoaning that Amazon’s stock kept rising while they continued to produce net losses year over year over year. Even now, I still see people complain that Amazon isn’t running large profit margins and that the valuation does not reflect its return to shareholders. What these people don’t understand is how value is captured by a high growth company and what levers a company is pulling to achieve growth and expand their economic moat. By posting this article I suppose I could be risking this being the top of their run, but something tells me that Amazon is going to continue growing at a relatively fast clip and increase their valuation beyond that of Apple in the next year or two.

Competitive Advantage

Amazon is very well run financially. Their financials are remarkably consistent and they manage to ensure they have little to no net income. Instead of having income that is taxable, they invest in wide economic moat. This is the competitive advantage that makes it hard for entrants to a market to be successful. Amazon doesn’t win markets because they’re Amazon. It is because they have invested billions of dollars to build a subscriber base that knows they can get product cheaply and quickly. With the rise of Amazon Web Services (AWS), Amazon is leveraging its knowledge of distributed scalable infrastructure to help companies be able to follow their model into scale.

How to Value a Company with No Profit?

The short answer here is the Rule of 40. The rise of high growth SaaS companies has lead to investors trying to find a way to effectively model a valuation for a loss-making company. This is tricky because these high growth companies are constantly trying to aggressively capture market share while finding a repeatable business model (i.e. cash flow producing). This balance leads to the Rule of 40 as a nice starting point for modeling valuations for high growth companies.

The Rule of 40 takes into account growth and balances it with profitability. Typically you will see it represented as trailing twelve month growth + EBITDA margin. So a company that grows at 40% per year with a -2%  margin would have a Rule of 40 score of 38. You can then use this in a simple linear regression model to get a baseline of a potential valuation. You can see at Kellblog that you can start to see the beginnings of a correlation between the Rule of 40 score and a valuation.

Applying it to your Investing Model

The problem that I’ve always had with investing in companies like Amazon, Shopify, Atlassian, or others with high growth is that nothing that I learned in traditional finance like discounted cash flow really provided a good proxy for value. There were too many assumptions. With the discovery of the Rule of 40 I’ve finally started to see patterns on revenue multiples related to growth and profitability and started to apply them in my own investments. I think I’ve been moderately successful in that regard and at this point I only invest in companies that have built significant economic moats and customer stickiness along with a reasonable valuation guided by the Rule of 40. I am by no means an excellent investor nor will I share any performance, but it has worked for me. Is it good in  risk-adjusted terms? Maybe not. There’s also the likelihood of having a lot of heat in this portfolio when the market starts to cool down, but when that happens I will likely invest more in companies that are investing in themselves.

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