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  1. 035Across listed SaaS peers, EV/ARR is roughly 0.25 times the Rule of 40 score. A company with Rs 50 crore of ARR and 55% growth trades at an enterprise value of Rs 600 crore. What free cash flow margin is the market pricing in, and what EV would the line give at its actual margin of minus 30%?Valuation riddlesHardSaaS-focused VCGrowth equity

    Try it first

    What free cash flow margin does the Rs 600 crore price imply?

    Show the worked solution

    The price implies a free cash flow margin of about -7%, and the line gives Rs 312.5 crore at the actual minus 30%. Rs 600 crore over Rs 50 crore is 12x ARR; divided by 0.25 that is a score of 48; less 55 points of growth leaves -7%. At minus 30% the score is 25, the multiple 6.25x and the EV Rs 312.5 crore, so the price assumes a 23-point margin gain worth Rs 287.5 crore.

    How do you run a peer line backwards?

    If you know that flats in a building sell for Rs 10,000 a square foot and one sold for Rs 1.2 crore, you can tell its size without measuring it: 1,200 square feet. A peer line works the same way. When the market prices software companies at a fixed multiple of their Rule of 40A score for software companies: revenue growth rate plus free cash flow margin, both in per cent. Forty or more is the conventional bar for a healthy balance of growth and cash generation. score, any observed price tells you the score the market is assuming. Rs 600 crore over Rs 50 crore is 12x ARR, and 12x over 0.25 is a score of 48.

    The relationship
    EVARR=0.25×(g+m)⇒12=0.25×(55+m)⇒m=−7%\frac{EV}{ARR} = 0.25 \times (g + m) \quad\Rightarrow\quad 12 = 0.25 \times (55 + m) \quad\Rightarrow\quad m = -7\%
    EV/ARRenterprise value divided by annual recurring revenue, here Rs 600 crore over Rs 50 crore
    grevenue growth, 55 points
    mfree cash flow margin, the unknown
    0.25the slope of the peer line, multiple per point of score
    What it says in wordsSet the observed multiple equal to the line, and the only unknown left is the margin the price assumes.
    Peer EV/ARR against Rule of 40 score, with the line EV/ARR = 0.25 x score0102030405060700x6x12x18xRule of 40 score = growth % + free cash flow margin %priced: 12x, score 48actual: score 25, 6.25x+23 ptsPrice Rs 600 cr / ARR Rs 50 cr= 12x, so score 48Margin priced: 48 - 55 = -7%Actual margin -30%: score 25Line value 6.25x = Rs 312.5 crPrice paid for improvementRs 287.5 crore
    At 12x ARR the company sits on the peer line at a Rule of 40 score of 48, which needs a margin of -7%; at its actual score of 25 the line gives 6.25x, so Rs 287.5 crore of the price pays for a 23-point margin improvement.

    What is the price paying for that the company does not yet earn?

    Run the line forwards with the actual numbers. Growth of 55 plus a margin of minus 30 is a score of 25, worth 6.25x ARR, or Rs 312.5 crore. The gap of Rs 287.5 crore is what the market pays today for the company moving its margin from minus 30% to -7%, a 23-point improvement, without giving up growth. An investor buying at Rs 600 crore should ask how plausible that improvement is and how soon it must arrive.

    How far can you trust the line?

    A ten-company scatter fitted with one slope is a rough guide. The line explains the middle of the peer set well and the edges badly, so a company at either extreme of growth or margin will often sit far from it for reasons the score does not capture. The score also weights a point of growth the same as a point of margin, which markets do not always do. Treat the implied margin as a question to put to management rather than a fact about the company.

    Where candidates lose it

    The common loss is stopping at a score of 48 and calling that the margin, or forgetting that growth is already in the score. The margin is what is left after subtracting the 55 points of growth: -7%.

    The second loss is answering both numbers without saying what the gap means. The interviewer wants to hear that Rs 287.5 crore of the price is a bet on margin improvement, and that a buyer at Rs 600 crore is paying for it in advance.

    What the interviewer asks next

    • If growth slows to 40% and the margin improves to minus 10%, what EV does the line give?
    • Why might the market pay more for a point of growth than for a point of margin?
    • What would you check before using a listed peer line to price a private Series C round?