Analyzing SaaS Companies: ARR, Churn, and the Rule of 40

Introduction

Analyzing SaaS companies means focusing on recurring revenue economics rather than one-time sales. Annual recurring revenue, churn, customer acquisition cost, lifetime value, and the Rule of 40 are the core signals that tell you whether a cloud software business is scaling efficiently.

Why does this matter to you as an investor? SaaS firms often trade on future cash flows and unit economics. If you don’t understand how subscriptions grow, how customers leave, and how profitable growth really is, you can misread valuations and risks.

In this article you’ll learn practical definitions, formulas, and examples using real tickers like $CRM and $SNOW. You’ll see how to compute ARR, measure churn and net retention, evaluate CAC versus LTV, and interpret the Rule of 40 for different growth stages.

• ARR is the central revenue baseline for SaaS, and growth rate beats raw revenue for valuation context.
• Distinguish gross churn, net churn, and dollar-based net retention, because each tells a different story about customer health.
• CAC payback and LTV:CAC ratio measure whether growth is sustainable; aim for LTV:CAC above 3x and payback under 12 months for early-stage companies, though norms vary by stage.
• Rule of 40 combines growth and margin into one benchmark, but apply it in context of stage, gross margins, and reinvestment needs.
• Cohort analysis and unit economics are more informative than headline metrics; dig into cohorts, contract lengths, and sales efficiency.

What is ARR and why it matters

Annual recurring revenue, ARR, converts recurring contract revenue into a standardized annual number. For subscription SaaS, ARR is the single best shorthand for the size of the recurring business and a baseline to judge growth percentages.

ARR is calculated by annualizing recurring fees. For example, a customer paying $100 per month contributes $1,200 to ARR. Companies will report new ARR, expansion ARR, churned ARR, and net new ARR to show the sources of change.

Practical ARR example

Imagine a company with 10,000 customers paying $1,000 per year on average. ARR equals 10,000 times $1,000, or $10 million. If the company adds $3 million in expansion ARR but loses $1 million to churn in the same year, net new ARR is $2 million and ending ARR is $12 million.

When you compare companies, look at ARR growth rate rather than absolute ARR alone. A $1 billion ARR company growing 20% is in a different class than a $50 million ARR company growing 80%.

Churn: the leaky bucket

Churn measures how much revenue or how many customers a business loses over time. For SaaS, churn is often the single biggest long term risk. If churn is higher than growth, ARR will shrink no matter how much you sell.

There are two main churn concepts: customer churn, which counts contracts lost, and revenue churn, which measures lost revenue. Revenue churn can be gross or net. Gross revenue churn excludes expansion, while net revenue churn includes expansion and contractions.

Churn formulas and interpretation

1. Customer churn rate = (Customers lost during period) / (Customers at start of period).
2. Gross revenue churn = (ARR lost to downgrades and cancellations) / (ARR at start of period).
3. Net revenue retention (NRR) = (ARR at period end from starting cohort, including expansion and contractions) / (ARR at period start from that cohort). NRR above 100% means expansion outweighs churn.

Example, suppose starting ARR from a cohort is $10 million, the business loses $800k to downgrades and churn, but gains $1.2 million from upsells, then ending ARR for that cohort is $10.4 million and NRR is 104%.

CAC, LTV, and payback: are customers profitable?

CAC is customer acquisition cost, the total sales and marketing spend to acquire new customers over a period, divided by number of new customers acquired. LTV, lifetime value, estimates the present value of future gross profits from a customer. Comparing LTV to CAC shows whether growth is bought at sensible economics.

Common formulas

1. CAC = Total sales and marketing expense for period / Number of new customers acquired in period.
2. LTV simplified = Average revenue per account, ARPA, times gross margin, divided by churn rate. LTV = ARPA times Gross Margin / Churn Rate.
3. Payback period = CAC / (ARPA times Gross Margin), expressed in years or months.

Practical example, suppose ARPA is $1,200 per year, gross margin on subscription revenue equals 80% after hosting and support costs, and annual churn rate is 10%. LTV = 1,200 times 0.8 divided by 0.10, which equals $9,600. If CAC to acquire that customer was $3,200, LTV:CAC is 3x and payback period is $3,200 divided by (1,200 times 0.8) = 3.33 years, or about 40 months.

For many public SaaS firms, investors prefer LTV:CAC above 3x and CAC payback under 12 to 24 months, depending on company stage. Early-stage companies may accept longer paybacks if capital is cheap, while mature platforms should demonstrate faster payback and higher LTV.

Rule of 40: growth vs profitability

The Rule of 40 is a quick benchmark that adds revenue growth rate and profit margin, with a combined total ideally equal to or greater than 40. It gives a single-line view that balances growth and efficiency.

Which margin should you use? Public SaaS investors commonly use free cash flow margin, operating margin, or EBITDA margin. Gross margin is not appropriate because it does not reflect operating costs to grow the business.

Applying the Rule of 40 with examples

Example A: a company growing ARR at 60% with negative free cash flow margin of minus 30% yields 30, which fails the Rule of 40. Example B: a mature company growing 20% with 25% FCF margin yields 45, which passes the Rule of 40.

Interpretation depends on stage. High-growth companies often trade with wide negative margins while investors accept the tradeoff. At the same time, a high-margin business with zero growth can still pass the Rule of 40, but may be less attractive if growth is the priority for your portfolio.

Putting the metrics together: a checklist for investors

When you research a SaaS company, run this prioritized checklist. Start with ARR and its growth rate. Then check net revenue retention and cohort trends. Next, look at gross margins, CAC and LTV, and CAC payback. Finally, apply the Rule of 40 to assess the balance of growth and profitability.

1. ARR level and growth rate, year over year and sequential.
2. Net revenue retention, ideally above 100% for expansion-led businesses.
3. Gross margin on subscription revenue, typically 70 to 90% for SaaS.
4. CAC, CAC payback period, and LTV:CAC ratio.
5. Churn rates by cohort, not headline churn only.
6. Rule of 40 using FCF or operating margin, with context by stage.

For example, $CRM often posts NRR well above 100% and high gross margins, which supports higher valuations. By contrast, a newer cloud company like $MDB may show very strong growth but negative margins and longer CAC paybacks. Your valuation expectations should reflect where the company sits on that spectrum.

Real-World Examples

Here are three condensed case studies to show the metrics in action. These examples use simplified numbers to keep the math clear while reflecting typical SaaS reporting patterns.

$CRM style large incumbent

Starting ARR: $10 billion, YoY ARR growth 20%, gross margin 80%, FCF margin 15%, NRR 110%. Rule of 40 = 20 + 15 = 35, slightly below 40, but strong NRR and large ARR justify premium multiples. CAC payback is short because upsells and renewals dominate sales efficiency.

$TEAM style mid-market grower

Starting ARR: $1 billion, growth 35%, gross margin 75%, FCF margin minus 10%, NRR 105%. Rule of 40 = 35 - 10 = 25, which fails the rule. Investors may accept this while expansion continues, provided CAC:P&L dynamics improve over time.

$MDB style high-growth cloud native

Starting ARR: $500 million, growth 60%, gross margin 70%, FCF margin minus 40%, NRR 102%. Rule of 40 = 60 - 40 = 20. High growth masks deep reinvestment. Watch churn, CAC payback, and the path to margin improvement.

Common Mistakes to Avoid

• Relying on headline churn only, without cohort analysis. How to avoid: ask for cohort retention tables and dollar-based net retention numbers.
• Using gross margin in the Rule of 40. How to avoid: use operating or free cash flow margins to capture growth spend.
• Comparing LTV:CAC across stages indiscriminately. How to avoid: compare peers at similar ARR and growth stages, and adjust expectations for enterprise versus SMB focus.
• Ignoring contract length and seasonality. How to avoid: check average contract term, weighted average contract length, and annual vs multi-year deal mix.
• Valuing expansion without considering concentration risk. How to avoid: look at top customer concentration and the portion of ARR from the top 10 customers.

FAQ

Q: What is a healthy churn rate for SaaS?

A: It depends on customer mix and contract type. For B2B enterprise SaaS, logo churn under 5% annually and revenue churn under 3 to 10% are common goals. SMB-focused businesses often see higher churn, sometimes 10 to 30% annually, which must be offset by low CAC and strong unit economics.

Q: How should I interpret Net Revenue Retention versus gross churn?

A: NRR captures expansion and shows whether existing customers are growing in value. Gross churn tells you how much revenue is being lost before upsells. A firm with moderate gross churn but high NRR can still expand ARR because upsells more than replace losses.

Q: Is a Rule of 40 fail always bad?

A: No, context matters. Early-stage, high-growth companies may intentionally trade margin for market share. But persistent failure to close the gap without a clear path to profitability is a red flag. Check trajectory, gross margins, and capital efficiency.

Q: How do I handle multi-product firms when calculating ARR and churn?

A: Break ARR and churn out by product or segment when possible. Dollar-based net retention by product and cross-sell rates will reveal whether one product is subsidizing another, and if expansion is sustainable across the portfolio.

Bottom Line

At the end of the day, analyzing SaaS companies means focusing less on one-off revenue and more on recurring economics. ARR sets the scale, churn shows the leak, CAC and LTV reveal whether growth is profitable, and the Rule of 40 summarizes the tradeoff between growth and margin.

When you evaluate SaaS stocks, dig into cohort retention, dollar-based net retention, contract terms, and CAC payback. Compare peers by stage and product mix, and demand transparency on unit economics. If you do that, you’ll be able to separate durable subscription businesses from the ones that only look good on the surface.