This Simple Tool Could Help You Find the Next Amazon

Editor's note: Software stocks have taken a tumble recently. And for the folks struggling to pick through the wreckage of today's software space, Joe Austin of our corporate affiliate Chaikin Analytics offers a solution... In today's piece, updated from a recent issue of the free Chaikin PowerFeed e-letter, Joe explains the simple formula investors can use to spot the companies that can follow through on their growth promises.

Jeff Bezos once said that "overnight success" takes about 10 years...

He should know.

Bezos started Amazon (AMZN) as an online bookstore in 1994. But the company didn't turn a profit until 2003.

That year, it made $35 million... after losing $149 million the previous year.

By that point, Amazon had lost more than $3 billion since going into business.

During those early years, plenty of people were skeptical. But Bezos eventually convinced everyone that Amazon was a tech company, not just a bookseller.

Bezos proved that early losses can lead to massive success. But not every CEO who preaches this philosophy can deliver on it. As we'll explain today, one formula can help you identify the companies that can actually follow through on their growth promises...

Adam Neumann made similar promises about turning losses into riches. Neumann ran WeWork, a company that provides coworking spaces.

Like Bezos, Neumann also tried to convince folks that WeWork was a tech company...

He said that WeWork was more than a company that rented office space. In his words, it was a "physical social network" offering "space as a service."

WeWork also struggled to earn a profit in its early years. Between 2016 and 2022, the company lost nearly $16 billion.

But despite some surface-level similarities, the outcomes for Amazon and WeWork couldn't be more different...

Today, Amazon is one of the most valuable companies in the world. WeWork failed its initial attempt to go public... and eventually went bankrupt.

So how do investors separate losses that lead to success from ones that lead to failure? It comes down to how they weigh the trade-off between growth and profitability.

The challenge is that fast growth often requires burning cash.

Get this right, and you back the next Amazon. Get it wrong, and you fund the next WeWork.

As it turns out, at least when it comes to software companies in the tech industry, one formula can help investors make this call...

Find the Companies Making Empty Promises

It's called the "Rule of 40"...

Calculating it is simple... You add a company's revenue growth rate to its profit margin. If the total hits 40% or higher, the company is considered healthy.

A venture capitalist named Brad Feld helped popularize the idea in 2015. The concept emerged in Silicon Valley during the 2010s as investors looked for a better way to evaluate fast-growing software companies.

These kinds of businesses often sacrifice profitability to invest in sales and product development. (Slow-growing, mature companies should be generating healthy profits.)

If a software company consistently keeps this metric above 40%, it's performing well. If not, it needs to either accelerate growth or improve margins.

Today, we have a great opportunity to put the Rule of 40 to work...

Software stocks have taken a beating. And when everything is down, it's tempting to assume that all software companies are equally troubled.

The Rule of 40 can help identify which companies are genuinely struggling and which ones are just caught in a market downturn.

To see this in action, I recently compiled data on all software companies in the Russell 3000 Index with market caps of at least $1 billion.

That resulted in a list of 167 companies.

For revenue growth, I used the trailing 12 months of quarterly data. I then calculated profit margin two ways, which is consistent with industry practice...

The first was EBITDA margin (earnings before interest, taxes, depreciation, and amortization divided by revenues). The second was free cash flow ("FCF") margin (FCF divided by revenues).

And the results were startling...

Based on the EBITDA metric, only 43 companies met or beat the Rule of 40. Based on the FCF metric, only 51 companies passed.

In short, only 1 in 4 companies was making the grade based on EBITDA. And based on FCF, only 1 in 3 made the cut.

These numbers are sobering. But before you go all-in on using the Rule of 40 to make investment decisions, understand its limitations...

The Rule of 40 isn't perfect. You shouldn't use it as the "make or break" measure in picking stocks.

Companies that fail the Rule of 40 aren't automatically bad investments. But they deserve a closer look to see whether their growth or profitability will improve.

And even if a company passes the Rule of 40, you need to understand whether its blend of growth and profitability will continue.

Meanwhile, I'm monitoring the State Street SPDR S&P Software & Services Fund (XSW) to spot opportunities in the software industry...

What's Next for This Software Downturn

XSW has gotten clobbered recently...

We can see that with the help of the Power Gauge. That's a tool we use at Chaikin Analytics to analyze the markets. It gathers investment fundamentals and technicals into a simple rating of "bullish," "neutral," or "bearish."

Right now, the Power Gauge rates XSW as "very bearish." And the ratings breakdown for the fund's individual holdings doesn't look good...

Out of 138 companies with ratings, 54 are "bearish" or worse. That compares with 77 in "neutral" territory... and only seven with "bullish" or better grades.

But software remains a massive growth industry. And it's a crown jewel of American innovation.

This downturn could turn into an opportunity at some point... if you know which companies to focus on.

The Power Gauge will help us know when the industry as a whole is starting to turn. But even when that happens, not every stock in the space will deserve your attention. It's critical to be selective.

Remember, the growth versus profitability trade-off is a perennial issue with tech companies. Losses only turn into riches when a business is building something real.

The Rule of 40 can help you figure out which companies could be the next Amazon... and which might be the next WeWork.

Good investing,

Joe Austin

Editor's note: Marc Chaikin says that beginning February 24, we could see the biggest turning point in the market since 2022. And thanks to a brand-new rating in his Power Gauge system, you could potentially spot the biggest earnings beats before they occur. This breakthrough offers the chance to spot which AI stocks could double or triple your money this year... and it's a secret that could reshape your approach to investing in 2026 and beyond.