Does Berkshire Hathaway CEO Greg Abel's New Favorite Stock, Alphabet, Achieve the Rule of 40?

New Berkshire Hathaway Chief Executive Officer Greg Abel appears to have chosen his favorite stock early in his tenure.

Since Abel took over for Warren Buffett as the new chief of Berkshire Hathaway, the company has plowed more than $20 billion into Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) through open-market purchases and direct equity offerings.

Alphabet, the parent company of Google, is now the fourth-largest position in Berkshire's portfolio when combining both Class A and Class B shares it owns.

Abel appears to have chosen his horse early. Does Alphabet achieve the Rule of 40?

Image source: Alphabet.

What is the rule of 40?

There are many financial metrics that investors use to assess the health and future prospects of a stock, and one is the Rule of 40. The Rule of 40 is used by investors to assess how well a company balances growth and profitability and is frequently applied to software companies.

The formula looks at revenue growth, typically on a year-over-year basis, combined with net profit margin. If the total is above 40%, then a company has done a good job of growing profitably. If it's below 40%, the company may not be investing efficiently.

Companies that do achieve the Rule of 40 can receive higher valuations. It's also important to note that investors don't have to use net profit margin. They can use operating margin, free-cash-flow margin, or EBITDA (earnings before interest, taxes, depreciation, and amortization) margin.

How Alphabet performs

We can assess Alphabet's performance using the Rule of 40, based on profit margin, operating margin, and free-cash-flow margin.

I looked at Alphabet's year-over-year revenue growth on a constant-currency basis and reviewed all metrics for the full year 2025 and the first quarter of 2026 to assess both the most recent numbers and the 12-month performance. The large conglomerate generated 15% annual revenue growth in 2025 and 19% in the first quarter of 2026.

Data source: Alphabet.

As you can see, when it comes to operating margin and profit margin, Alphabet passed the Rule of 40 with flying colors. Artificial intelligence (AI) has been a huge boon to companies like Alphabet, with their cloud businesses benefiting immensely.

Alphabet has also rolled out its own large language models (LLMs), which many investors believe are competitive with perceived leaders like Anthropic's Claude and OpenAI's ChatGPT.

The area where Alphabet has struggled is when using free-cash-flow margin in the Rule of 40. Perhaps even more concerning is that this metric declined in the first quarter of 2026.

This actually makes sense, given Alphabet's capital expenditures (capex) and the company's capex forecast as it continues to build out AI infrastructure. Alphabet has projected between $180 billion and $190 billion in capex this year.

Some Wall Street analysts even foresee the company's free cash flow turning negative during the next few years.

Just one data point

Investors should understand that many financial metrics are used to evaluate a company's health. You should never lean too heavily on any individual metric as the basis for an investment; instead, use the sum of your research to inform your decision-making.

In this case, the Rule of 40 indicates that Alphabet's AI initiatives and investments have so far paid dividends. But the struggles with free-cash-flow margin also indicate the company may be overspending on AI, a concern that many investors have with other AI hyperscalers, too.

Many investors, including Abel, likely expect the investments to pay off, but if you also start to see Alphabet struggle with the Rule of 40 when using operating and profit margins in the formula, that would be a major red flag about these AI infrastructure investments.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet and Berkshire Hathaway. The Motley Fool has a disclosure policy.