Re-evaluating the Rule of X: A Cloud Leader’s Perspective on Balancing Growth and Profit

The increased interest rates signify a shift in focus for businesses as they return to considering the cost of capital and free cash flow generation. As companies strive to adhere to conventional heuristics such as the Rule of 40, which was popularized by Bessemer, executives are realizing the significance of free cash flow (FCF) margins in comparison to growth and the potential 1:1 trade-off. However, the equal weight assigned to growth and profitability for late-stage businesses is flawed and has led to misguided business decisions.

Our Point of View

For businesses with reasonable FCF margins, growth should continue to be the prevailing priority. Even though there is a substantial focus on efficiency, the conventional Rule of 40 math is fundamentally incorrect when a company approaches breakeven and becomes free cash flow positive.

The world has leaned excessively towards an FCF margin-oriented approach as opposed to a growth-focused mindset, which is counterproductive for growing efficient businesses. Long-term models demonstrate that even in constrained markets, growth should be valued at least ~2x to 3x more than FCF margin.

Why?

Although a margin increase has a linear impact on value, an increase in growth rate can have a compounding impact on value. In light of this, we suggest that even the most cautious financial planners can securely utilize a ratio of ~2x growth over profitability for late-stage private businesses. Public companies with lower costs of capital can use a ~2 to 3x multiple, provided that the growth is efficient.

With that said, the actual ratio fluctuates widely in the short term, ranging from ~2x to ~9x in the past few years. However, over the long term, the ratio generally settles at 2x to 3x more value for growth over profitability. This is further supported by public market valuation correlations when the relative importance of growth versus FCF margin is backtested.

In Summary

The financial strategies of companies should reassess the conventional wisdom that places equal importance on growth and profitability for late-stage businesses. Instead, a greater emphasis on growth over FCF margin is recommended, with a safe ratio of ~2x to 3x more value for growth, which aligns with long-term growth models and market valuations. By making this adjustment, businesses can better position themselves for long-term success.

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