EV/Sales and the Rule of 40

Many fast-growing companies, particularly software businesses, spend heavily on growth and post little or no profit for years, which makes P/E ratios meaningless, there are no earnings to divide by. Investors instead value these companies using EV/Sales: enterprise value (market cap plus net debt) divided by annual revenue, since revenue exists even when earnings don't.

But a revenue multiple alone can't tell you whether fast growth is being bought at a reasonable cost or is burning cash unsustainably. The Rule of 40 is a quick health check: add a company's revenue growth rate and its profit margin (often free cash flow margin), and if the sum is at or above 40%, the growth is generally considered healthy, whether it comes mostly from growth, mostly from profitability, or some mix of both.

Worked example. A software company grows revenue 35% a year but posts a -10% free cash flow margin: 35 - 10 = 25, well below the Rule of 40 threshold, flagging that growth is currently coming at a heavy cash cost. A peer growing revenue only 22% but with a +20% free cash flow margin scores 22 + 20 = 42, clearing the bar despite slower growth, a reminder that the rule treats growth and profitability as substitutes, not that growth alone is what matters.