Rule of 40's ignored assets

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Heuristics have flaws

Just like dollar-cost-averaging seem wise to many (nope), so does the 'rule of 40' do to the self-selected few.

But profit margin does not have a profitability monopoly. Two companies with similar margins will have different profitability depending on their asset efficiency.

Return on Invested Capital = NOPAT/Invested capital

Quick maths: ROIC = NOPAT/Sales ("profit margin") x Sales/Invested Capital ("asset turnover"). High margins generally hint of differentiated products while a high asset turnover implies cost leadership/efficient operations.

Recaps: rule of 40 = sales growth + a profit margin. Asset efficiency is as such not rewarded or, in the case of companies trying to disguise as software firms, punished!

Enter "Magic number"

Long-term prospects are likely better for Company 1, even though both firms have the same R40 score. Company 1 seem to have a more efficient return on S&M. Company 1's R&D investments (expensed over IS..) should give higher future returns. Company 2 has less wiggle room for R&D as cash is burned on the S&M growth altar.

A screen does not take into account 'Legacy Moats' vs. 'Reinvestment moats'

ROICs/R40s/Magic numbers are not created equal. High returns on prior invested capital (sunk investments) are not necessarily valuable without opportunities to deploy incremental capital at high rates. It can merely be a proxy of what to expect!

P.S. Yes, determining invested capital is an arcane science for the Patagonia initiated few. When dabbling in private investing there might even be books for the IRS, books for the life partner and, of course, the actual ones. Chinese books also have a tendency to act naturally - nothing to see here:

P.S. 2 Time to go back to selling plasma, semen and even your poop (!) to buy asset intensive companies screening favourably for R40?

Disclosures: Short feces (not investment advice).