What is the ‘rule of 40’ and how can it help stock picking?

TechOne boss Ed Chung says he won't get carried away  or 'overplay' the so-called 'rule of 40' metric that has become key to measuring how investable software companies are.

TechnologyOne CEO Ed Chung says ‘we’ve always been driven by strong profitable growth in our DNA’.

TechnologyOne chief executive Ed Chung says he does not want to “overplay” the so-called “rule of 40” that has become key to measuring the performance of software companies, despite delivering a bumper score.

But what is the rule, and how can it help you pick stocks?

Young tech companies often generate buzz – and dizzying valuations – as they develop at breakneck speed, prioritising capital growth over profitability.

This is fine during a strong economy. Investors can watch their wealth grow as the company grows, even if it will be years before they receive a dividend.

Think Atlassian. Its shares have soared more than 660 per cent since it listed a decade ago. Meanwhile, the ASX 200 has increased almost 65 per cent.

But in more uncertain times, the rule of 40 – which holds that a company’s revenue growth plus profit margin should be 40 per cent or more – becomes more critical.

It has been a key metric, particularly when assessing the ­investability of software-as-a-service companies. If it’s above 40, it’s healthy. If it’s below, executives must pull other levers to generate growth or cash. It is considered a more accurate measure of company performance than return on investment.

ASX-listed accounting software company Xero has been one of its biggest adherents ­locally, with chief executive Sukhinder Singh Cassidy saying the company is focusing on delivering on that metric before it contemplates paying a dividend.

Brisbane-based TechnologyOne, which pays dividends, is also measured on the rule, generating a score of 49 in the six months to March 31.

But Mr Chung said he did “not want to overplay it”.

“I don’t want to change anything we do, number one, and I don’t want the market to potentially run away with it,” Mr Chung said.

“We’ve always been driven by strong profitable growth in our DNA. Our DNA is to grow profit. That’s always been the way, and then to grow ARR (annual recurring revenue), that’s always been the way. So it’s nothing new for us. It’s not like the rule of 40 has changed us or will change us.”

TechnologyOne floated in 1999 at $1 a share, just before the dotcom bust. Its shares have since surged more than 4000 per cent to $40.15, valuing the company at $13.14bn.

Mr Chung says the key to success is to be consistent and ­focused, aiming to deliver 10-15 per cent profit growth each year.

“We’ve got a good (rule of 40) score, but our DNA says we don’t focus on that score. Our DNA says keep growing your ARR at the same rates, and keep growing your profit at the same rates.”

Last week, Mr Chung announced that TechnologyOne’s ARR had passed $500m for the first time – 18 months earlier than planned – and plans to hoist that number to $1bn by the end of the decade. Wilsons analysts are confident the company can achieve that goal.

Mr Chung said its UK business would be critical to delivering on that ambition, as would its new SaaS+ product, which threatens to puncture the enterprise resource planning software strategies of the top consulting firms such as Deloitte, KPMG and Accenture.

He says TechnologyOne ERP software can be implemented in less than 300 days, and plans to slash that number to less than 30. This compares with rivals taking 2000-plus days.