Hot Money Monday: The Rule of 40 and how Morningstar evaluates Saas tech stocks

It’s increasingly difficult to assess SaaS-based tech companies
Morningstar advises using Rule of 40 and Investment Payback
Morningstar rates the following ASX stocks using those metrics

The world of software companies has changed. In the past, software was sold as a one-off purchase with customers paying upfront.

But now, many software companies operate under a model called Software-as-a-Service (SaaS), where customers pay smaller, ongoing subscription fees instead.

This shift has made it harder for investors to figure out how profitable these companies really are, because the money spent on getting new customers (like through advertising and sales) is spent upfront, but the revenue from these customers is earned over many years.

To make sense of this, an explanatory note from research firm Morningstar said that investors must use different metrics (or measures) to assess profitability.

One such metric is the Rule of 40.

What is the Rule of 40?

The Rule of 40 is a metric used to assess a SaaS company’s overall performance.

It adds up the company’s revenue growth and profit margin. A total score of 40 or more is seen as a positive sign of a healthy company.

Rule of 40 = Company’s revenue growth (%) + Profit Margin (%)

Example: A company with 20% revenue growth and 20% profit margin would score 40, which indicates that it’s balancing growth and profitability well.

The Rule of 40 helps investors evaluate both growth (which may lower profit margins in the short-term) and profitability, giving a better picture of the company’s long-term potential.

“The Rule of 40 is a valuable metric to better assess the real profitability of SaaS companies, compared with ROIC (return on invested capital), because it also incorporates the growth that comes from a company’s investments,” said Morningstar.

However, the Rule of 40 isn’t perfect.

It’s focused on current profitability, which may not fully reflect the long-term potential of early-stage SaaS companies, especially those that are growing quickly and investing heavily upfront.

“The Rule of 40 has several inherent limitations, especially for investments that take longer than one year to generate returns.”

Which is why we should also use Investment Payback

According to Morningstar, Investment Payback is another important metric that shows how long it takes for a company to recoup the money it spends on sales and marketing (customer acquisition) or research and development (R&D).

It addresses the issue that the Rule of 40 may overlook: the timing mismatch between when the company spends money and when it sees the return.

Investment Payback = Annual Cash Inflow / Initial Investment

Example: If the company invests $100,000 in a project and expects it to generate $20,000 in annual net cash inflows, the payback period would be: 100,000 / 20,000 = 5 years.

“We propose Investment Payback as an additional metric to address some of the Rule of 40’s shortcomings,” wrote Morningstar.

This metric helps investors understand how quickly a company’s investments start to pay off.

By looking at both Investment Payback and the Rule of 40, investors get a fuller picture of how a company is performing in the long term.

Morningstar’s stock tips

When applying the Rule of 40 to its coverage, Morningstar found that the metric did a reasonable job of reflecting the differences in quality of companies.

“Some of our highest-quality names, WiseTech Global (ASX:WTC) and Technology One (ASX:TNE), averaged scores in the 30s, which are strong results.

“It should be noted here that the threshold of 40 is a high bar to meet, especially over a longer period.”

Using the Investment Payback metric, SiteMinder (ASX:SDR) screens as an attractive investment opportunity in Morningstar’s universe.

“We estimate SiteMinder generates strong internal rates of return on its investments, and we expect this to eventually flow through to its Rule of 40 score and ROIC.”

Objective Corp (ASX:OCL) is another tech company Morningstar ranks using these metrics, and it scored near the top.

However, Hansen Technologies (ASX:HSN) scored near the bottom of the ranking.

“Although Hansen has a defensible existing customer base with high switching costs, it is unable to attract significant new customers and has shown itself unable to increase prices for existing customers in line with inflation,” said Morningstar.

This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decision.