https://www.5iresearch.ca/questions/text/rule+of+40#answer163822. Could you explain further why this model doesn't seem to work for companies in other industries?
For example, ATD has a low single digit free cash flow margin and would not meet the rule of 40 threshold, but it has proven to be a consistently good investment over the years despite that fact. Why doesn't its poor profitability hold it back and what other criteria would you consider important in lieu of the rule of 40 that help you identify it as a good investment?
“Rule of 40” is the formula to quickly evaluate businesses with high recurring revenue and high margins (software is the most commonly referred to). The idea is that companies that are prioritizing growth could justify lower profitability and vice versa.
Other companies also become great performers over the years and the rule of 40 still does not apply like AMZN or WMT. These are mental models, which may be different for various industries, but the common themes for great compounders over the years involve some (or all) of these characteristics like strong organic growth, long reinvestment runway and high returns on capital, share repurchases. We would simply view it as an heuristic. Not all rule of 40 names will be good stocks/companies and many non-rule-of-40 names will be great stocks/companies.
Some other 'heuristics' we would like are return on equity, high top-line growth, high margins.
Authors of this answer, directors, partners and/or officers of 5i Research and/or affiliated companies have a financial or other interest in AMZN, WMT.