Spotify’s Long-Term Prospects Outweigh Present Valuation Concerns

Spotify (NYSE:SPOT) stock is overvalued at this time, based on my analysis. However, long-term trends in digital audio streaming and Spotify’s top position in the industry that seems probable to continue over the next decade means I am rating the stock a Hold.

Company Overview

For investors already acquainted with Spotify, please skip ahead to the ‘Future Growth Trajectory’ section.

Spotify is a leader in digital music, podcasting, and video streaming. It operates through a freemium model, including free, ad-supported content and a subscription-based ad-free option. Most of its revenue comes from premium subscriptions, with the rest coming from advertising. The dual revenue stream has been instrumental in the company capturing a wide user base whilst also monetizing effectively.

The firm invests heavily in technology, specifically in algorithms and data analytics, to help personalize the listening experience. It recommends tailored content for individuals, which is foundational to its user engagement strategy. It has multiple partnerships with top-tier content creators.

Future Growth Trajectory

Spotify’s future growth may be hinged on emerging market penetration, its continued expansion into podcasts and non-music content, and deeper personalization as a result of machine and deep learning artificial intelligence integrated into individual Spotify accounts and preferences.

Investors should take note of the continuing shift toward digitalization, accelerated by the pandemic and highly beneficial for Spotify.

It is also important to consider the market penetration and significant moat developed through Spotify’s partnerships. As of 2020, these included The Ringer and Bill Simmons, The Joe Rogan Experience, Kim Kardashian West, Warner Bros. and DC, Michelle Obama, Brené Brown, Megaphone, and The Duke and Duchess of Sussex.

The company’s path to sustainable profitability is going to be paramount to maintaining shareholder value long term. Increasing efficiency in operations is going to be critical to it scaling its earnings as its revenue growth eventually plateaus. Its cloud infrastructure is highly scalable and allows for the efficient management of extremely large sets of data inherent in its operations. Coupled with AI, its cloud platform could become a significant driver for higher margins over time.

Spotify will also want to differentiate itself from its competitors. It can do this most powerfully through its partnerships, but it has to be noted that there is significant competition from companies like Amazon (AMZN) Music, Apple (AAPL) Music, and others.

Consider also the fact that Spotify will likely be making significant acquisitions over the long term to remain relevant. With a lower total capital base than its major high-tech peers Amazon and Apple, it may struggle to retain profitability for a while to remain competitive.

Spotify has spent over $1.2 billion on acquisitions to grow its audiobook and podcast business from 2019 to Q2 2022. These included buying Findaway, a digital book distributor; Podsights and Chartable, offering podcast advertising measurement and analytics; and Sonantic, an AI voice platform creating realistic voices from text. Acquisitions prior to these included Betty Labs, Podz, Megaphone, The Ringer, Parcast, Gimlet Media, and Anchor.

Present Financials

Shopify has high growth but low profitability at this time relative to peers. Its forward revenue growth rate is 13.95%, a 319.06% difference from the sector median of 3.33%.

Yet, consider the much lower total revenue of Spotify when compared to the large-scale high-tech competitors who have exposure in the space:

Also note the lack of profitability that is the greatest red flag in the short term of investing in Spotify. I consider the stock a long-term play targeting stabilized profitability soon. Before then, some volatility could occur, primarily if the company fails to meet profitability estimates next quarter.

Some caution is warranted around its balance sheet, which presents an equity-to-asset ratio of just 0.3:

Short-Term Valuation Risk

Spotify’s forward P/E GAAP ratio is 68.64, which is a 311.71% difference from the sector median of 16.67. Understanding the valuation takes a nuanced approach, considering that we do not have stable earnings growth rates to work off when forecasting for the future. Nonetheless, I have used the $3.85 December 2024 EPS estimate as my starting value as listed as consensus from 26 analysts on Seeking Alpha:

I then used a 25% EPS annual growth rate as my average over the next 10 years. I used a 4% terminal stage growth rate following this and a 10% discount rate. My fair value estimate is $186, a -36.5% margin of safety on the present stock price of $253.78.

As such, I think it is wise to be cautious about allocating to Spotify at this time, and I am expecting some downside to come as a result of the present overvaluation by the market before long-term price growth resumes.

Competition Risks

Spotify’s competition risks are also of critical importance to consider in more detail to understand the long-term viability of investing in the stock. While significant growth in the digital music market is expected this decade, whether Spotify retains its top position in platform streaming technology is yet to be seen.

However, Goldman Sachs predicts Spotify will retain its leading market share in the industry in 2030, elucidated in the second chart below with data drawn from the ‘Music In The Air’ report.

Conclusion

Spotify is a good long-term investment, but I expect some volatility as a result of its potential overvaluation. I think that the digital audio streaming market will continue to develop some of the most important technologies in entertainment and education in the coming decades. Whether Spotify will retain its leading position or other disruptive technologies will take over will take careful monitoring of the market. In the meantime, if we can tolerate some price turbulence due to valuation concerns, my analyst rating for Spotify stock is a Hold.