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Evaluating Stock Selection in the SaaS Industry: The Effectiveness of the Rule of 40

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  • Lee, King Fuei

Abstract

The Rule of 40 is a popular financial guideline used by software-as-a-service (SaaS) industry participants to assess the operational health of the companies. This paper investigates the effectiveness of the Rule of 40 as a stock selection criterion. Our study analyses a sample of 1771 SaaS companies worldwide spanning the period 2003-2022. The findings demonstrate that the Rule of 40 adds value and delivers a moderately high Sharpe ratio as a stock selection tool. A modified rule, the SaaS Investing Rule of 65, is proposed and found to outperform the Rule of 40 in identifying relative winners and losers within the SaaS space. The effectiveness of the rules raises practical implications for investors and analysts. Additionally, we explore the effectiveness of alternative versions of the Rule of 40 using different measures of profitability, as well investigate whether the returns are driven by traditional style factors.

Suggested Citation

  • Lee, King Fuei, 2024. "Evaluating Stock Selection in the SaaS Industry: The Effectiveness of the Rule of 40," MPRA Paper 121568, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:121568
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    References listed on IDEAS

    as
    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. James L. Davis & Eugene F. Fama & Kenneth R. French, 2000. "Characteristics, Covariances, and Average Returns: 1929 to 1997," Journal of Finance, American Finance Association, vol. 55(1), pages 389-406, February.
    3. Martin L. Leibowitz, 2002. "The Levered P/E Ratio," Financial Analysts Journal, Taylor & Francis Journals, vol. 58(6), pages 68-77, November.
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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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