Term · Profitability & Growth
Rule of 40
In briefThe Rule of 40 adds revenue growth and profit margin and requires at least 40 percent in total. It checks the balance of growth and profitability, especially for software stocks. Because the margin used varies, it is only a guide, not an exact criterion.
Definition
The Rule of 40 is a rule of thumb, primarily for software and growth companies, according to which the sum of the revenue growth rate and profit margin (often EBITDA or free cash flow margin) should be at least 40 percent. It is intended to assess the balance between growth and profitability. A value below 40 is regarded as a sign of an unbalanced profile.
How it is calculated
Formula. Rule of 40 = Revenue growth rate in % + Margin in % ≥ 40 %
Why it matters for small caps
For young small-cap growth stocks, the Rule of 40 helps distinguish expensive growth without profitability from viable models. It is, however, only a rough guide.
Common misreadings
- The Rule of 40 is misunderstood as a hard valuation rule, even though it is only a rough rule of thumb without a uniform margin definition.
In the process
Frequently asked
Which margin is used in the Rule of 40?
Inconsistent, often EBITDA or free cash flow margin. Because the definition varies, comparisons should always use the same margin measure.
Which companies is the rule intended for?
Primarily high-growth software and subscription models, where temporarily high growth can offset low profitability.
What is the biggest weakness of the rule?
It is a rule of thumb without a fixed definition, ignores debt and the quality of growth, and does not replace a full analysis.
Related terms
Education only, not investment advice. Ranges and thresholds are didactic orientation values, not an official standard.