What Is the Rule of 40? How Growth Plus Margin Scores Software Stocks and How Traders Can Use It

The Rule of 40 is a quick test for software companies: add the annual revenue growth rate to a profit margin, and a healthy business should total at least 40%. It became a common shorthand among venture investors in the mid-2010s, with investor Brad Feld often credited with popularizing it, and it now appears in earnings calls and analyst notes. The idea is that growth and profit can be traded against each other, so a company can run at a loss if it grows fast enough, or grow slowly if it is highly profitable.

The formula

Rule of 40 score = revenue growth rate (%) + profit margin (%)

Growth is usually year-over-year revenue growth, sometimes measured on recurring revenue. The margin is most often free cash flow margin (free cash flow divided by revenue) or adjusted EBITDA margin. Different companies and analysts pick different measures, so the same business can post different scores, which is why the choice has to be stated.

What the score signals

• Efficiency of growth. A high score suggests the company is not buying growth at an unsustainable cost, or is not sacrificing growth to protect profit.
• Flexibility. A company scoring well above 40 can choose to reinvest in growth or let margins expand. Below 40, management often has to pick one: improve efficiency, pricing or retention, or accept slower growth.
• Valuation support. Investors have tended to pay premium multiples for companies that stay above the line over time, which is why traders watch it around earnings.

By our calculation, two companies can reach the same score from very different positions. A company growing 45% with a -5% free cash flow margin scores 40, and so does one growing 15% with a 25% margin. They carry different risks: the first depends on funding and continued demand, the second on defending a slower growth rate.

A worked example with real numbers

Take Tempus AI's third-quarter 2026 results. By our calculation, 23% revenue growth plus an adjusted EBITDA margin of about 6.2% gives a score near 29, below 40. Tempus is a diagnostics and data business rather than a pure software company, so the rule is an imperfect fit, but the example shows the mechanics. The score would move up if growth held while margins widened. Our earnings coverage has the underlying figures.

Where the rule misleads

• Choice of margin. Adjusted EBITDA can exclude stock-based compensation and other costs. Free cash flow is harder to flatter, but can swing with timing of payments and collections. Compare like with like.
• Stock-based compensation. Heavy share-based pay can make adjusted margins look better than the economic cost to shareholders, which shows up later as dilution.
• One-time boosts. Acquisitions, a single large contract or a pricing change can lift growth for a few quarters without changing the underlying trend.
• Growth fades. Growth naturally slows as a company scales, so a score that is falling because growth is decelerating deserves more attention than one rising on cost cuts.
• It is a rule of thumb. The 40% line is arbitrary. Investors tolerate lower scores in strong markets and demand more profit in weak ones, and the rule works poorly for early-stage companies with deeply negative margins.
• It ignores quality. The score says nothing about customer retention, market size, competition or how concentrated revenue is.

How traders can use it

1. Use it as a screen, not a signal. It narrows a list of software names. It does not say when to buy or sell.
2. Read the trend. Compare the score over four to eight quarters. A steady or rising score is a better sign than one strong quarter.
3. Check the mix. Ask whether the score comes from growth, margin or both, and whether guidance supports it.
4. Verify the definitions. Find the company's non-GAAP reconciliation in its filings on the SEC site and recompute the score yourself with free cash flow.
5. Pair it with valuation. A high score is often already in the price. Compare the multiple with peers and with the company's own history before treating the score as a reason to own it.
6. Add other metrics. Gross margin, net revenue retention, stock-based compensation as a share of revenue and cash on hand fill in what the score leaves out.
7. Watch earnings reactions. A company that posts a strong score but guides growth lower can still fall, because the market trades the direction of the numbers as well as the level.

What to watch

• Definitions. Whether a company reports its own Rule of 40 score and which margin it uses.
• Guidance. Next-year growth and margin outlooks, which set the forward score.
• Dilution. Share count growth that offsets the margin gains.
• Chart context. Pair fundamentals with price action, such as the signals in our guide to upside and downside reversals.

Sources: The formula, its common margin measures and its limitations are widely used industry heuristics, and the worked example uses Tempus's reported third-quarter 2026 results. Non-GAAP reconciliations are in company filings at sec.gov. Items labeled by our calculation are our own arithmetic. This article is for education only, is informational only and is not investment advice.