SPOT: Is Spotify a good stock to buy?

A human-readable stock analysis, from a rational perspective

Recently I noticed how much I love Spotify’s product, and every month when I see the monthly charge of 19.90 NIS (the Israeli currency), I think to myself: “that’s fucking worth it”. I wonder how many of you who have Spotify (Premium) agree with me. I don’t think I’ll ever cancel my subscription — and when I realized that’s actually what I think, I figured I should check if the company itself is an investment opportunity or not.

Because Spotify is a company that’s built on subscriptions, the first thing I checked is the churn rate of their Premium users (just to see I’m not alone in how I feel about the product). It’s about 5%. That number (five percent) to me says a lot about the quality of the company — only 5% of the paid users leave every quarter, which means 95% stay, which means Spotify truly delivers value to its customers.

When I approach an analysis of a company in order to see if it’s an investment opportunity I generally have to check 2 things: that it’s a great company, and that the price is good. For example Apple, Facebook, Amazon, Tesla and Microsoft are all great companies, but their price (their market cap) is too high, and therefore to me they are not investment “opportunities”.

To be honest, even before I’ve read about Spotify deeply — I knew it is a great company (as I said I’m a very satisfied customer of it’s only product). All I have to figure out is whether the “price” is good, meaning whether or not Spotify’s market cap is low enough to make it an investment opportunity.

But how can we do that? How can we know if Spotify’s market cap is too high, too low, or approximately as it should be?

First it’s important to understand that it’s not science, it’s business, and in business to make decisions we need to make estimations even when the entire picture is not clear. These estimations will not be accurate, and we’ll have to make a lot of assumptions to reach them, but if we’ll follow one rule — these estimations will actually help us a great deal. This rule is pessimistic assumptions.

What do I mean by pessimistic assumptions? We’ll reach that in a moment.

I now wanna check if it’s worth it to buy Spotify’s shares. I see that it trades in a market cap of 62 billion dollars. To understand if it’s a low price (bargain), high price, or suitable price, I need to figure out how much money Spotify is going to earn in its entire existence. I’ll just mention that if the discussed company is actually a great one, I can assume that there’s a pretty good chance that it’ll be around even 30 years from now (if it’s not reasonable, the company is not great).

But how can I possibly estimate how much money Spotify is going to earn in its entire existence?

The answer is: it’s absolutely impossible. BUT, and that’s a very important “but” — I can try to estimate how much money Spotify’s going to make in the next 30 years under pessimistic assumptions. And if I can calculate how much money it’ll make in the next 30 years under pessimistic assumptions, I can get from there to it’s “pessimistic value”. If then I’ll see that the current price is around its pessimistic value — it is a good investment opportunity (only if the company is wonderful).

In the last paragraphs I’ve discussed a very important concept in valuations for investment purposes — I don’t actually need to know how to estimate the company’s value, I only need to figure out it’s pessimistic value. If I then buy at a price similar to (or lower than) it’s pessimistic value, I’ve dramatically reduced the risk of a long-term loss. And if I’ve chosen a wonderful company like Spotify, then it is very much likely that the pessimistic scenario will not occur — and who knows how much profit this company can generate for me if things will go well and it’ll stay great (this too can be estimated through optimistic assumptions, it’s just less critical for the decision).

Okay, so now that it’s clear to me that I need to calculate Spotify’s pessimistic value, how exactly am I supposed to do that?

In general (and I should put a huge “in general” on this entire post) — there are 2 ways I can do that:

1. To assume that Spotify’s current 144 million paid users are going to stay, and that the company is going from now on to invest only in keeping that number (144 million premiums) and maximize on profits, which means it’s not going to invest in growth (marketing and R&D) more than the required minimum. In addition, I assume that the subscription’s price is going to go up 1.88% a year, like the dollar’s inflation rate (which means the real price is actually not going to go up). Under these assumptions I get that Spotify’s present value is about 42 billion dollars (the calculation will be detailed in a moment), which is about two thirds of its current market cap (which is $62B).
2. To assume that Spotify’s going to invest a lot in growth in the following decade, and only then to maximize on profits, but with a pessimistic growth rate. For instance I have chosen that in the next 30 years their growth rate is going to be 2.5% a year (today it is 25%, but of course this growth rate won’t remain like that forever). I think that 2.5% is a pessimistic growth rate, and that there’s a good chance that in 30 years from now they’ll actually have 10 times more paid users (which translates to a yearly growth rate of 8%), but as I said — I need to reach a decision according to the pessimistic value, and not by the probable/optimistic value. In addition, I assume the price will go up at a rate of 2.5% a year (a bit higher than inflation). Under these assumptions I get that Spotify’s present value is about 47 billion dollars, which is about 75% of its current market cap.

If you’ve lost me in the last two paragraphs, I’ll sum it up shortly: I’ve talked about 2 ways to calculate Spotify’s pessimistic value. One is based on an imaginary scenario in which tomorrow Spotify stops investing in growth and just maximizes its profit from current users. The other is based on a realistic (but pessimistic) scenario, in which the company invests in growth and in the next 30 years achieves (in the aspect of paid users) a growth rate of 2.5% a year.

The calculation itself is detailed in this document, the first sheet presents the first scenario, and the second one presents the second scenario.

This calculation presents an estimation of Spotify’s revenues, and Spotify’s profits, every year from 2021 to 2050. The yellow part in the document is the present value of the future money Spotify’s going to make. Spotify’s value is simply the sum of the present value of all its future profits.

What do I mean by “present value”? It means that if Spotify will earn 2 billion dollars (net profit) in year 2050, those 2 billions dollars are worth today about 1.3 billion dollars. Why? Because if I would take 1.3 billion dollars today and buy 30-Year Treasury Bonds (0 risk), then 30 years from now, in 2050, I’ll have 2 billion dollars. This understanding, that a dollar 30 years from now is just like a different currency, and that it requires “conversion” to “today’s dollar” — is a very basic understanding in Finance, and it deserves a separate post.

To sum it up: Spotify’s pessimistic value is about 45 billion dollars, the company’s current price is 62 billion dollars, considering the fact it is a wonderful company, with tremendous growth opportunities that I haven’t even mentioned here (they know everyone’s taste in music, what do you think will be the next step?), paying an extra 35% on its pessimistic value sounds to me like a nice investment opportunity.

I’m going to buy Spotify’s shares, but of course I do not recommend that you do that as well — because even if everything I’ve written here sounds good and logical, you need to remember 2 things: 1. I don’t have a license to give advice in financial matters, or in any matter whatsoever; 2. Although Apple Music is shitty, Google’s Youtube Music is a scary competitor.