RJ Hamster
A Simple Metric for Weighing Growth Against Profitability
A Simple Metric for Weighing Growth Against Profitability
By Joe Austin, senior analyst, Chaikin AnalyticsJeff Bezos once said that “overnight success” takes about 10 years…
He should know.
In 1994, Bezos started Amazon (AMZN) as an online bookstore. But the company didn’t turn a profit until 2003.
That year, it made $35 million after losing $149 million the year before.
By that point, Amazon had lost more than $3 billion since going into business.
During those early years, plenty of people were skeptical. But Bezos eventually convinced everyone that Amazon was a tech company, not just a bookseller.
Bezos proved that early losses can lead to massive success. But not every CEO who preaches this philosophy can deliver on it…
Adam Neumann ran WeWork. The company provides coworking spaces. And Neumann made similar promises about turning losses into riches.
He also tried to convince folks that WeWork was a tech company…
Neumann said that WeWork was more than a company that rented office space. In his words, it was a “physical social network” offering “space as a service.”
Between 2016 and 2022, WeWork lost nearly $16 billion.
Today, Amazon is one of the most valuable companies in the world. WeWork failed its initial attempt to go public… and eventually went bankrupt.
So how do investors separate losses that lead to success from ones that lead to failure? It comes down to how they weigh the trade-off between growth and profitability.
The challenge is that fast growth often requires burning cash.
Get this right, and you back the next Amazon. Get it wrong, and you fund the next WeWork.
As it turns out, at least when it comes to software companies in the tech industry, there’s one formula that can help investors make this call…Recommended Links:
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Separating Real Growth From Empty Promises
The “Rule of 40” is simple…
You add a company’s revenue growth rate to its profit margin. If the total hits 40% or higher, the company is considered healthy.
A venture capitalist named Brad Feld helped popularize the idea in 2015. The concept emerged in Silicon Valley during the 2010s as investors looked for a better way to evaluate fast-growing software companies.
These kinds of businesses often sacrifice profitability to invest in sales and product development. (Slow-growing, mature companies should be generating healthy profits.)
Software companies consistently above 40% with this metric are performing well. Those below it need to either accelerate growth or improve margins.
Today, we have a great opportunity to put the Rule of 40 to work…
Software stocks have taken a beating. And when everything is down, it’s tempting to assume that all software companies are equally troubled.
The Rule of 40 can help identify which companies are genuinely struggling and which ones are just caught in a market downturn.
To see this in action, I recently compiled data on all software companies in the Russell 3000 Index with market caps of at least $1 billion.
That resulted in a list of 167 companies.
For revenue growth, I used the trailing 12 months of quarterly data. I then calculated profit margin two ways, which is consistent with industry practice…
The first was EBITDA margin (earnings before interest, taxes, depreciation, and amortization divided by revenues). The second was free cash flow (“FCF”) margin (FCF divided by revenues).
And the results were startling…
Based on the EBITDA metric, only 43 companies met or beat the Rule of 40. Based on the FCF metric, only 51 companies passed.
So when it comes to picking through the wreckage of software stocks today, remember that only one in four companies was making the grade based on EBITDA. Based on FCF, the number is only one in three.
These numbers are sobering. But before you go all-in on using the Rule of 40 to make investment decisions, understand its limitations…
The Rule of 40 isn’t perfect. You shouldn’t use it as the “make or break” measure in picking stocks.
Companies that fail the Rule of 40 aren’t automatically bad investments. But they deserve a closer look to see if their growth or profitability will improve.
And even if a company passes the Rule of 40, you need to understand if its blend of growth and profitability will continue.
Meanwhile, when it comes to opportunities in the software industry, I’m still monitoring the State Street SPDR S&P Software & Services Fund (XSW)…
The Software Space Still Looks Weak Right Now
As I said last week, XSW has gotten clobbered recently…
Right now, the Power Gauge still rates XSW as “very bearish.” And the ratings breakdown for the fund’s individual holdings still looks bad…
Out of 138 companies with ratings, 54 are “bearish” or worse. That compares with 77 in “neutral” territory… and only seven with “bullish” or better grades.
But as I also noted last week, software remains a massive growth industry. And it’s a crown jewel of American innovation.
This downturn could turn into an opportunity at some point… if you know which companies to focus on.
The Power Gauge will help us know when the industry as a whole is starting to turn. But even when that happens, not every stock in the space will deserve your attention. It’s critical to be selective.
Remember, the growth versus profitability trade-off is a perennial issue with tech companies. Losses only turn into riches when a business is building something real.
The Rule of 40 can help you figure out which companies could be the next Amazon… and which might be the next WeWork.
Good investing,
Joe Austin
Editor’s note: Later this morning, at 10 a.m. Eastern time, Joe will be joining Chaikin Analytics founder Marc Chaikin for a special event…
In short, they’ll be discussing a new way to spot which AI stocks could double your money this year… by foreseeing the biggest earnings beats before they occur, in combination with the Power Gauge. Last year alone, it pointed to seven stocks that more than doubled in a back test.
It’s your last chance to register to attend this free event – you can do so right here.
Market View
Major Indexes and Notable Sectors # HLD: BULLISH NEUTRAL BEARISH
Dow 30
+0.12%621 3S&P 500
+0.07%120287 91Nasdaq
+0.21%2253 25Small Caps
+1.32%618956 309Bonds
+0.55%Utilities
+2.76%326 2
— According to the Chaikin Power Bar, Small Cap stocks and Large Cap stocks are Bullish. Major indexes are mixed.* * * *
Sector Tracker
Sector movement over the last 5 daysUtilities+7.27%Real Estate+3.6%Materials+3.49%Energy+2.07%Consumer Staples+1.79%Industrials+0.57%Health Care-0.03%Communication-1.02%Information Technology-1.11%Consumer Discretionary-1.53%Financial-4.81%* * * *
Industry Focus
Biotech Services478413
Over the past 6 months, the Biotech subsector (XBI) has outperformed the S&P 500 by +31.52%. Its Power Bar ratio, which measures future potential, is Very Strong, with more Bullish than Bearish stocks. It is currently ranked #10 of 21subsectors and has moved up 1 slot over the past week.Top Stocks
ABBVAbbVie Inc.ARDXArdelyx, Inc.BIIBBiogen Inc.* * * *
Top Movers
Gainers
COIN+16.46%AMAT+8.08%
DXCM+7.59%
AKAM+6.83%
HOOD+6.82%LosersSTZ-8.04%NCLH-7.57%NVR-7.27%
EXPE-6.41%BLDR-4.84%* * * *
Earnings Report
Earnings SurprisesEXAS
Exact Sciences Corporation Q4 $-0.21 Missed by $-0.29MRNA
Moderna, Inc. Q4 $-2.11 Beat by $0.53DCH
Dauch Corporation Q4 $0.07 Beat by $0.09* * * *
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