Discounted Cash Flow Analysis of Spotify from November 2017
It has been almost a year since Spotify, the Swedish music streaming service went public on April 4, 2018. Opening that day at $165.90 a share, Spotify has traded as high as $198.99 and as low as $103.29 in its first year as a publicly traded company. The stock closed on 3/15/19 at $141.91 with a market cap of $25.7B.
Back in the Fall of 2017, my students at Sierra Nevada College and I decided to attempt a Discounted Cash Flow analysis of Spotify. Based on leaked financial information and a new (at the time) study by Goldman Sachs on the anticipated growth of the music industry we attempted to construct the “stories we must tell” in order to value the company.
According to Goldman Sachs, the music streaming industry, which we computed based on Spotify’s revenue and percent of the market to be 8.3 billion euro in 2016, would grow to $34 billion dollars (a the time of the analysis 29.2B euro) by 2030 for a 9.34% annual growth rate. In Q4 2016, Spotify had a 35% market share, we decided that was likely to shrink to 25% over the next 10 years with competitors like Apple, Google, and Amazon building similar offerings. We computed that Spotify’s cost of revenue had been around 85% and felt that too would shrink, this time to 70%, as the cost of music licensing became their main costs. Like most venture-backed startups, Spotify had been losing large amounts of money, but based on a financial analysis we found we assumed their operating margin would move towards 82%. Finally, based on data pulled from Damodaran Online, we assumed a Sales to Capital ratio of 1.88, tax rate of 22%, and ending discount rate of 10.8% (we decided to start at 15%). On the date of analysis, the dollar to euro conversion rate was .86.
Here, you can see our assumptions and sources.
Using this data, we projected out to 2030 (13 years) and then assumed a future growth rate of 5% to compute our terminal value:
As a market leader, we decided Spotify had a very low chance of failure, only 10%. Adding cash, subtracting debt, and adding the value of investments to the value:
We came to a valuation of $5.8B back in November of 2017.
This is a far cry from the $25.7B that Spotify is valued at today. It is always interesting to see which of our assumption we might need to tweak to get to where the market believes the company is today. For example, if we assume that Spotify “wins” this market with a 75% market share that gets us to a $16.6B valuation:
If we assume Goldman Sachs is being too conservative and the music streaming industry will grow by 20% through 2030 we get to $13.8B:
And, if we assume that music licensing fees plummet and Spotify only has to pay 25% in the future, we get to $18.8B
As we all know, predicting the future is impossible and much of the data we based this analysis on is leaked and perhaps questionable. However, as I tell my students, it’s always interesting to see what sort of stories we need to convince ourselves of to justify the valuation the market puts on a company like Spotify.
Spotify was a pioneer and an early leader in their space, but three of the largest, most well run companies in the world; Apple, Amazon, and Google, offer essentially the exact same service. Apple, in particular, appears to have made significant gains in 2018 and has likely surpassed Spotify in paid users.
In addition to fending off these three rivals, we can see that other parts of their “story” must change in order to justify their current valuation. Will the economics of the business improve? Will the market grow more than current forecasts? Some combination of both? Only time can tell.
