What Investors Should Know About Spotify's Valuation

Spotify (SPOT 2.77%) is in a league of its own...which isn't great for investors.

In this segment from Industry Focus: Tech, analyst Dylan Lewis and Motley Fool contributor Evan Niu discuss what we know so far about Spotify's valuation metrics. Find out where the company opened and closed in its first day on the market, how its valuation stacks up to other recent tech IPOs, why Spotify doesn't really have any comparable companies for traditional valuation metrics, and more.

A full transcript follows the video.

This video was recorded on April 6, 2018.

Dylan Lewis: Now that shares are out there, Evan, we have a sense of the valuation of this business, and this is something that we didn't have before, because there was nothing out there, there was nothing really to anchor to, aside from going back to recent rounds and recent transactions on the private markets. What are we looking at in terms of valuation?

Evan Niu: When they opened, the total market cap was right about $30 billion. By the close of the first day, it was closer to $26 billion because the stock went down a little bit. Actually, really quick, just to mention, that compares to their most recent private funding round valuation of $8.4 billion, which was way back in 2015. That was just a funding round. That doesn't include all the activity that took place since 2015 in terms of private market activity. But, just another data point to compare it against. In terms of valuation, that put it at around 5X sales since on a trailing 12-month basis they've done about $5.3 billion in revenue. So, I mean, that's pretty expensive.

Lewis: Yeah, we cannot look at P/E for this business because Spotify is not profitable. It's expensive. It's funny, though, because you look at some of the recent tech issuances, you go back to Dropbox, which recently hit the public market, Snap, and Twilio, those were extremely rich by comparison. Dropbox went public around 10X trailing sales. Snap went public at 25X trailing sales, and Twilio went public at 15X trailing sales. So, a lot of these businesses, by comparison, seem extremely rich. I think the important thing to look at here is, those are not perfect comps, though, for Spotify. Just because they're in the same tech space and they're these hot IPOs does not mean that it's a good apples to apples comparison.

Niu: Right. And that's going to be real challenge going forward. So much of valuation in general is really predicated upon comparable valuation, you compare it to the peers and what the rest of the industry looks like. And every industry is different. So, that's how all valuation works. In Spotify's case, there is no comparable pure-play. They are the largest music streaming company on Earth. And all the other companies that are pure-play streaming, like Pandora or whatever, they're tiny in comparison, and their business models are very, very different fundamentally. So, there's not really a good way to measure Spotify. There's no one to measure it against. I mean, Apple is the next-closest competitor, and they have half the subscriber base as far as premium subscribers. But obviously, Apple is a humongous company that does many other things, so you can't really compare valuations there.

So, I think that there is a possibility that Spotify ends up being one of those companies where you can't really rely on traditional valuation metrics very much because they don't have anyone to compare it against, and they're unrivaled in terms of scale and their position in the industry they operate in. They also have some opportunities to really reshape the whole music industry. There's a lot of value in those things, so I think it's going to be kind of tricky.

Lewis: And I was fighting for a company that I think could possibly be in that space and be something that you could stack them against, and the best thing I could come up with was Netflix. That's actually a company that has, at times, traded in that 5X multiple. It's been up a little bit more recently. But even there, there are major differences. Netflix pulls in a lot more on the gross margin side than Spotify does, and Netflix has original content, which is just a totally different business than what Spotify is in. Spotify does this undifferentiated kind of commodity business with the music streaming. Their biggest differentiator is these Discovery playlists that we were talking about before, and the music curation. So, I don't even know if that's a good parallel.

Niu: Right, exactly. I don't think Spotify is going to get into the original content game any time soon, make their own music.