Rule of 40 and 60: What the Numbers Can and Cannot Tell Me
When people hear that I invest, the first question is often, “Which company should I buy?” I cannot know which stock will rise next, and a single formula cannot answer that question. My goal is narrower: create a repeatable first pass that reduces the number of companies requiring deeper research.
Traditional measures answer different questions. PER and PBR describe price relative to earnings or book value. DCF depends heavily on assumptions about discount rates and long-term growth. Forward estimates depend on analysts and company guidance. None is useless, but none allows a clean comparison without understanding the business and accounting behind it.
Why I began with the Rule of 40
The Rule of 40 is commonly used when discussing software businesses:
revenue growth (%) + profitability margin (%) ≥ 40It recognizes a tradeoff. A young company may accept a low margin while expanding quickly; a mature company with slower growth should normally produce more profit. I later raised the cutoff to 60 as a personal screening choice, not because 60 is an academic threshold or a guarantee of quality.
The useful part
The score forces me to look at operating results before narratives:
- Is revenue actually growing?
- Is the company retaining part of that revenue as profit?
- Has the balance between growth and profitability improved or weakened?
- Is the result stable across several reporting periods?
During a market decline, these questions are more useful to me than repeatedly watching the share price. A maintained score does not mean the price must recover, but it tells me whether the operating picture has changed.
The dangerous part
The apparent simplicity can create false confidence.
- A weak comparison period can make growth look extraordinary.
- EBITDA margin and operating margin are not interchangeable.
- Banks, insurers, REITs, and industrial companies cannot be ranked as if their revenue and margins meant the same thing.
- High growth can require heavy capital spending or stock-based compensation.
- A wonderful company can still be a poor investment at an excessive price.
For these reasons, I now describe Rule of 60 as a candidate screen, not a final validation rule. Original filings, cash flow, debt, dilution, valuation, and industry cyclicality must be reviewed separately.
How it fits my portfolio
Most of my assets remain in diversified core funds. I use this screen only for a limited satellite allocation, after a company has already attracted attention through index changes, operating results, or a research question. Even then, passing the screen does not require me to buy, and falling below it does not automatically require me to sell.
The value of the process is not certainty. It is leaving an auditable trail: the date, source fields, formula, result, and reasons for the final decision.