The Rule Of 40 For Stocks? What Investors Should Know About It

Dear Investor,

I believe strongly in frameworks and formulas that can be applied across many industries to find good stocks.

For any formula to earn a place in my analysis toolbox, it must be easy to understand, grounded in logic, and work more often than it fails.

I am always looking for new ways to evaluate businesses. Recently, I adjusted a formula that has been in front of investors for years but is often used incorrectly.

Before introducing today’s rule, let’s start with its predecessor.

The Rule of 40

One of the best tests of a management team is how well it delivers shareholder returns while the business grows. This is especially true in software-as-a-service (SaaS) companies.

Although SaaS is known for high growth, only a small number of companies consistently grow revenues by 30–40%.

This is where the Rule of 40 comes in. It states that a SaaS company’s revenue growth rate plus its free cash flow margin should be at least 40. A score above 50 is considered excellent.

The rule is mainly used for early-stage, high-growth tech companies to identify fast growers that are at least free cash flow positive.

When applied to most public companies, however, the rule breaks down. Most businesses do not grow that fast, and even fewer do so profitably.

It is rare to find a public company growing revenue above 30% with low free cash flow margins, or generating free cash flow margins above 30% with low growth.

That leads to my adjustment.

The Rule of 20

(with two conditions: free cash flow margins of at least 10% and positive revenue growth so that we avoid the trap of investing in a very profitable company with shrinking revenue)

I chose this number for three reasons.

First, I wanted a formula that works across industries, not just in tech. Most public companies are mature and grow more slowly.

Second, based on my experience, businesses with free cash flow margins below 10% are poor long-term investments.

Third, most mature companies do not grow revenue consistently above 10%.

A total score of 20 strikes a reasonable balance between growth and profitability.

The closer a company’s score is to 20, the better. Anything above 20 is excellent for long-term investors.

This rule also filters out low-growth, low-margin industries such as utilities, telecommunications, and capital-intensive manufacturing.

In addition, companies that lose money (common among recent IPOs) do not pass the screen. They only appear once investing starts to make sense.

How to use the Rule of 20

• Spot outliers within an industry.If a manufacturing company scores close to or above 20, it deserves closer analysis.

• Look at the 5-year average score.The higher the average, the stronger the business model. Often, results are driven less by management skill and more by what the business model allows. If forced to choose, pick a great industry run by mediocre managers over a poor industry run by smart ones.

• Compare quarterly results.Most investors focus on headlines and earnings per share. This formula highlights sudden improvements in growth and profitability that others may miss.

A Company That Doubles the Standard

When I apply this framework to real businesses, I look for companies that not only clear the Rule of 20 threshold but exceed it by a meaningful margin. These are the businesses where both growth and profitability work in concert, creating compounding value for shareholders.

I recently analyzed a company that scores 40 on this metric, delivering 7% revenue growth alongside a 33% free cash flow margin. This combination puts it well into “excellent” territory and suggests a business model with considerable durability and pricing power.

If you’re interested in seeing how this framework applies to a specific investment opportunity, I’ve prepared a detailed stock report on this business.

Here are the facts:

• Zero debt

• Consistent free cash flow margins around 30%

• Less than 5% of its cash flow is used for capital expenditures

• Digital infrastructure player that’s essential for its niche

• Dividend of around 4%

• Trading at a free cash flow yield of around 5.2%

• No competition

• Founder-led for more than 3 decades

• Small-cap

👉 Download the report 👈 and see if this matches what you look for in a long-term holding.

Until the next issue.

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Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.

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