A Reinvention of the Rule of 40? Invest Smarter with the Rule of X!
Growth vs. Profitability: Why the Rule of X Is the Better Metric!
Investors have long sought simple, actionable formulas to navigate the complexities of the stock market.
Joel Greenblatt’s Magic Formula, which emphasizes buying companies with high earnings yields and returns on capital, is one such example.
Another is the Rule of 40, a popular metric for assessing SaaS businesses by balancing growth and profitability.
Now, I recently came across a new concept—the Rule of X—which builds on the foundation of the Rule of 40 to offer a more nuanced approach for evaluating companies (and cloud businesses specifically), particularly in fast-growing sectors like technology and SaaS. The article was published by Byron Deeter and Sam Bondy from Bessemer Venture Partners and can be found here.
What Is the Rule of X?
The underlying formula of the Rule of 40 is pretty straightforward:
Revenue Growth (%) + Profit Margin (%) ≥ 40
What kind of profit margin are we talking about? It depends. Typically, the Rule of 40 uses either:
EBITDA margin (Earnings Before Interest, Taxes, Depreciation, and Amortization).
Operating margin (EBIT)
Free cash flow (FCF) margin
Net income margin (less common)
Overall, the Rule of 40 aims to help evaluate whether a company—typically a SaaS company—is delivering a reasonable balance of growth and profitability.
For instance, consider a high-growth SaaS company with a revenue growth rate of 35% and a profit margin of 10%. Adding these values together gives a Rule of 40 score of 45%, indicating that the company exceeds the threshold and demonstrates a strong balance of growth and profitability.
Now compare this to a more mature SaaS company that grows at only 10% but boasts a profit margin of 35%. Its Rule of 40 score is also 45%, showing that while it may not grow as rapidly as the first example, its profitability more than makes up for the slower growth rate.
Both companies meet the Rule of 40 standard, but the underlying drivers—growth versus profitability—differ significantly.
The Rule of X, however, refines this approach by assigning greater weight to growth—an adjustment that reflects the compounding nature of revenue expansion in these industries. Its formula looks something like this: