Investors are constantly on the lookout for a “foolproof” way of making money in the markets. Unfortunately, certainty is the last thing investors will find in the markets. Those who embrace the uncertainty will reap better investment results.
Nevertheless, investors should pursue a sound investment methodology when navigating the markets. One such method that Phillip Securities has extensively researched on is the Rule of 40.
The Rule of 40
The basic premise behind the Rule of 40 is that one year’s revenue growth rate plus ebitda margin should exceed 40% as a high level gauge of performance for software companies.
The Rule of 40 emphasises the importance of finding companies that are able to manage the balance between growth and profitability to create long-term value. The growth and profitability of a company are usually at odds with each other. To drive growth, the company would need to incur expenses.
Finding the right mix or balance between the two can be tricky. The Rule of 40 tries to balance and provide a trade-off between them. Investors are usually willing to tolerate low profits or even losses as long as a company is demonstrating strong growth.
See also: Valuing vice stocks
Let us now look at some stocks that may have the potential for longterm capital appreciation based on the Rule of 40.
The Trade Desk (TTD)
The Trade Desk is a digital advertising company that provides a platform for its customers to purchase advertising space. The company does not buy or own any media or advertising assets. Instead, it offers an online advertising platform for customers to access advertising campaigns in a variety of channels, ranging from display, social, mobile, video, and more. Its clients would then purchase this access, with the promise of being more effective at reaching a targeted audience, offering more granular feedback about the effectiveness of an advertisement. The AI that the platform taps on enables customers to optimise their spending based on budget, geography, and target audience.
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Unlike many companies in the software space, TDD is profitable and has no long-term debt. For the past five years, its customer retention rate has been consistently above 95%. Although the stock trades at rich valuations, the rise of connected TV is a growth driver that could justify those valuations. A greater portion of advertising spend will make the shift from traditional television to connected TV in the coming years. According to financial services firm Stephens, US advertising spend in the connected TV space will grow from a rough estimate of US$9 billion ($12.32 billion) to US$72 billion in the coming years.
As the economy rebounds, coupled with the shift in trends of the advertising market, the interest from ad buyers is expected to shift as well. This shift is poised to benefit TDD as a leader in the digital advertising space.
Atlassian (TEAM)
Atlassian is an Australian cloudbased software company that designs and develops enterprise software. The company offers project management, collaboration, issue tracking, integration, deployment, and support services. Some of its tools include Jira for business management and project tracking, Trello and Confluence for collaboration and tracking of projects and documents, Bitbucket and Bamboo for coding and managing software releases, and Atlassian Access for cloud security.
Since Atlassian went public in 2015, its total revenue has nearly quadrupled from US$457 million in FY2016 to US$1.6 billion in FY2020. The company transitioned to a subscription-based business model and saw its recurring sales increase sevenfold. Other sources of revenue grew at a comparatively slower speed, but the shift in business model gave Atlassian a stable foundation of sales to build on.
The Covid-19 pandemic sped up Atlassian’s pace of growth last year as companies across the globe were forced to work remotely, accelerating the demand for Atlassian’s workplace collaboration products. In the last quarter of FY2021, the company added over 23,000 net new customers, doubling y-o-y. The company finished the year by topping 200,000 customers and US$2 billion in revenue.
Upstart Holdings
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Upstart provides a cloud-based lending platform that uses a unique proprietary model driven by artificial intelligence to make a more accurate evaluation of one’s creditworthiness than traditional credit scoring. For consumers, this improves access to credit at lower interest rates. For Upstart’s partner banks, this improves profitability and loan underwriting quality, reducing the risk and costs of lending.
Upstart’s revenue has more than quadrupled in the past three years, with full-year 2020 numbers rising 42% from the previous year. Upstart’s platform handled more than 300 million loans last year, with annual growth in volume averaging at 62% since 2017.
Despite only being publicly listed in December 2020, Upstart is already profitable. Its adjusted net income surged more than fivefold y-o-y. More importantly, Upstart’s growth has come without deterioration in credit standards. Fraud rates have remained steady even as more of the platform’s loans become fully automated, proving the validity of Upstart’s business model.
Upstart’s CEO and co-founder Dave Girouard has considerable experience in the technology industry. Previously as president of Alphabet’s Google Enterprise division, he was instrumental in the development of Google’s cloud applications business. Girouard also has substantial interest in the financial success of Upstart, with a massive 17% stake in the company.
Currently, Upstart is in the business of originating personal loans and preparing to enter the auto loan market. Earlier this year, the company announced that it would acquire auto retail software specialist Prodigy Software. It also aims to broaden its scope of services in the future to cover mortgages, student loans, and credit cards. This would open up a bigger addressable market and more business opportunities in time to come.
Quantitative evaluation
Next, let’s see how the above companies stack up, using the metrics in the Rule of 40. To smoothen year-to-year fluctuations, we use the three-year average y-o-y revenue growth and three-year average ebitda margin.
As investing legend Benjamin Graham once said: “The market is like a voting machine in the short run and a weighing machine in the long run”. At certain points in time, we may notice stocks where their relative valuations do not commensurate with their Rule of 40 scores.
For example, a common metric used to judge whether a growth stock is expensive or cheap is the price-to-sales (P/S) ratio. A stock with a higher P/S ratio is more expensive than one with a lower P/S ratio.
Comparing the three companies, TDD has the highest Rule of 40 score, but the lowest P/S ratio — much lower than Upstart’s whopping P/S ratio of 344.89. This could mean that at current price levels, TDD is a better bargain than the other two companies.
Investors can use the Rule of 40 as a stock selection criterion for high-growth companies. These companies tend to spend heavily on sales, marketing and research and development to spur revenue growth. The Rule of 40 helps you to sift out companies that are not yet profitable but offer strong revenue growth prospects. Today, many investors use it to assess any fast-growing digital-economy company.
Investors and traders with a bigger risk appetite may consider using contracts for differences (CFDs) to gain greater exposure to these stocks with smaller capital outlay.
Khoo Gek Han is a dealer (CFD) at Phillip Securities
Cover photo: Joshua Mayo/Unsplash
