Software Valuations: How to Use the Rule of 40

The Rule of 40 metric for determining a software company's attractiveness to investors is a simple guide that often explains why they pay so much for "growth at a ridiculous price." Yes, GARP for software investors is very different than conventional metrics.

In the video that accompanies this article, I show the relative valuations of dozens of SaaSy software leaders and how to use the Rule of 40 to make better comparisons.

One name that is "off the charts" in terms of both growth and valuation is Snowflake SNOW, which by the time you are reading this will have reported its Q2 results and outlook.

Snowflake claims that inside their proprietary Data Cloud, organizations can collaborate with seamless performance, security, and unlimited access to governed data...

Wherever data or users live, Snowflake delivers a single and seamless experience across multiple public clouds. Snowflake’s platform is the engine that powers and provides access to the Data Cloud, creating a solution for data warehousing, data lakes, data engineering, data science, data application development, and data sharing.

Why Would Anyone Pay 45X Sales?

Investors are currently paying over 45 times sales for SNOW's projected topline next year of $1.8 billion. Yep, that's an $83 billion market cap.

But that valuation is also based on 87% revenue growth this year and 62% next year.

And that's the first consideration when computing the Rule of 40: the revenue growth rate.

Then you simply take that absolute value (hopefully it's positive) and add some metric of profitability like EBITDA (positive or negative, as a percentage) or margins.

According to the progenitor of the rule, Silicon Valley venture capitalist Brad Feld, if this math gets you over "40," you have a worthy SaaS investment to consider. As I explain in the video, the Rule of 40 is not the final arbiter of software values, but merely a starting point and common-ground reference for many investors and analysts.

Since Feld and his VC ilk specialize in risky money-raising rounds long before a software company goes public, they are pretty good a spotting ideas with potential. But even a veteran will tell you they often fall in love with ideas that never pan out. So using a quick growth screen like this can sometimes sort out the bad seeds, even for us non-VC who are investing in public softies.

You might be surprised to learn that the original SaaS beast, CRM nearly nails the 40 mark. This is remarkable for such a mature company. But according to KeyBanc analysts, CRM scores over "38" for its forward revenue growth + FCF margin.

Of course, CRM's valuation is attractive too at just 8 times forward sales. I really wish I had been paying better attention to CRM when it was on sale near 7X, bouncing off of $205 in March and May in a long consolidation since big new highs last August above $280.

But I was focused on my favorite software player, Square SQ, which consistently trades at 5-6X sales.

Why Does NVDA Trade at 20X Sales?

In the video, I also shout out to the excellent Dan Ives, MD of Equity Research at Wedbush, who was on TD Ameritrade Network with @OJRenick Tuesday to preview CRM earnings tonight where he's expecting a "mammoth" quarter. He said...

"I think this is one where we look back, and this is the start of the rocket ship starting to regain fuel going into 2022."

It makes sense when you look at CRM's fundamental growth numbers -- a 38 on the Rule of 40 says it all -- and its price chart which could be ready to jump out of a year-long "cup" that may just skip the "handle" and go to new highs.

Although NVIDIA NVDA won't be mentioned by any software analysts in their Rule of 40 calculations, I happen to believe that what supports a 20X price/sales valuation for this unique GPU chip maker is its heavy reliance on hardware + software stacks to make "massively parallel architectures" accessible and useful for corporations and scientific research institutions doing heavy data mining, modeling, and automation/AI development.

This is what institutional investors have finally recognized as NVDA has surged this summer and become a must-own in the FANGMAN suite.

Bottom of the Rule of 40 Barrel

Two other names I look at which fall down hard in the Rule of 40, despite strong double-digit revenue growth, are AI and Fastly. The reason they falter, even with 34% and 19% topline projections, is that their FCF margins are big negative numbers that virtually erase their sales growth contributions.

You'll see what I mean in the video charts where I also review my 2019 thesis for why software valuations were headed to the stratosphere. Those trend markers have aged well and appear to be still in play...

Software Valuations and the Rule of 40

How is it that large investors are still piling into software stocks trading at over 20X sales?

There are at least 4 major catalysts...

1. Software is primarily immune to the current tariff battles

2. Software is part of a secular "technology super cycle" as it vaults productivity while taming costs in nearly every industry

3. Software is "the brains" of innovation, with nearly infinite capability to shrink, manipulate, and enhance time and space

4. Software lives in its own "valuation stratosphere" based on the Rule of 40

That year (2019) I began calling the industries that comprise SaaS, IaaS (Infrastructure-as-a-Service), and other Software applications and platforms that make use of cloud computing, The SOFTOSPHERE -- and not just to make a doubly cute "cloud" and "valuation" reference but to highlight what a dramatic agent of change the Software universe now represents in economics and society.

When you think about investors who would never pay over 20X sales for a company, you can imagine how many could use a primer in the Rule of 40 that ignites and sustains such valuations. As more catch on, the multiples just expand.

And after tonight's SNOW and CRM numbers, we'll know a lot more about what they will pay.

Disclosure: I own shares of AI, SQ and NVDA for the Zacks TAZR Trader portfolio.

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the TAZR Trader portfolio and is the author of the influential Technology Super Cycle report that solved the high productivity + low inflation puzzles of disruptive innovation.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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