As well as interest rates After returning to historical norms, the world returned its focus to the cost of capital and free cash flow generation. Companies work 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 Bessemer helped popularize). Executives at both private and public cloud companies often believe that free cash flow (FCF) margins are just as important (if not more important) than growth and that the trade-off is 1:1. Many financial executives like the 40 Rule for its clarity, but giving equal weight to growth and profitability to late-stage companies is flawed and has caused misguided business decisions.
We have a take
Growth should remain the primary priority for companies with adequate FCF margins. While the focus on efficiency is justified, The traditional rule of 40 is completely wrong When you approach the break-even point and turn free cash flow positive.
The world has shifted too much to an FCF margin mindset over a growth mindset, which is backwards for growing efficient companies. Long-term models show that even in tight markets, growth should be valued at at least 2x to 3x more than free cash flow margin.
Giving equal weight to growth and profitability to late-stage companies is flawed and has caused misguided business decisions.
Why?
While increasing margin has a linear effect on value, increasing growth rate can have a multiplier effect on value. We show the detailed math below, and it is confirmed by general market valuation correlations when you test the relative importance of growth versus FCF margin. The actual ratio fluctuates wildly in the short term – ranging from ~2x to ~9x in the last few years – but in the long term, the ratio typically stabilizes at a value 2x to 3x greater for growth over profitability.
We recommend that even the most conservative financial planners can safely use a growth ratio of 2x on profitability for late-stage private companies; Public companies with low costs of capital can use approximately 2 to 3 times more (as long as growth is efficient).