Like interest rates have returned to historical norms, the world has refocused on the cost of capital and free cash flow generation. Companies are working hard to conform to traditional heuristics like the Rule of 40 (i.e., the idea that the sum of revenue growth and profit margin should equal 40%+, a metric that Bessemer helped pioneer). popularize). Executives at public and private cloud companies often believe that free cash flow (FCF) margins are as important (if not more) than growth and that the compensation is 1:1. Many finance executives love the Rule of 40 for its clarity, but assigning equal weight to the growth and profitability of late-stage companies is flawed and has led to poor business decisions.
Our opinion
Growth should remain the top priority for companies with adequate FCF margins. While the emphasis on efficiency is well founded, The traditional mathematical rule of 40 is totally wrong. as you approach breakeven and turn free cash flow positive.
The world has excessively pivoted towards an FCF margin mentality instead of a growth mentality, which is overdue for the growth of efficient companies. Long-term models show that even in tight markets, growth should be valued at at least 2-3x FCF margin.
Assigning equal weight to the growth and profitability of late-stage companies is misguided and has led to poor business decisions.
Because?
While an increase in margin has a linear impact on value, an increase in growth rate can have a compounding impact on value. We show detailed calculations below, and they are confirmed by public market valuation correlations when backtesting the relative importance of growth versus FCF margin. The actual ratio fluctuates wildly in the short term (between ~2x and ~9x in recent years), but in the long term, the ratio typically stabilizes at 2x or 3x more value for growth than profitability.
We recommend that even the most conservative financial planners can safely use a ratio of ~2x growth to profitability for late-stage private companies; public companies with lower costs of capital can use a multiple of ~2 to 3x (as long as growth is efficient).
Image credits: Bessemer Venture Partners
