A great way to build wealth is to buy and hold growth stocks for the long term. It's a wonderful feeling to watch your portfolio increase in value over the years and decades while you simply buy right and sit tight. With this strategy, the only thing an investor has to do is prospectively identify strong companies, buy shares at a reasonable price, and have the discipline to be patient.
One such growth stock with market-beating potential is Spotify (SPOT -1.42%). It operates in a fast-growing industry, has numerous ancillary businesses that could help accelerate its growth, and trades at a reasonable valuation.
Durable growth in music streaming
Spotify's core business is music streaming, which it has been doing for over a decade. For those who don't know, the company offers subscription services for ad-free music listening, which costs around $1 to $15 a month, depending on what type of plan you want and what country you are in. At the end of the third quarter, Spotify had 172 million premium music subscribers, up 19% year over year, with an average revenue per user of $4.90.
Third parties estimate that the company has a 32% market share in music streaming worldwide. Backfilling that to Spotify's 172 million subscriber base, there are approximately 537 million people that subscribe to a music streaming service, or 6.8% of the world's population.
Investors shouldn't expect that there will ever come a time when 100% of the global population will be paid subscribers to music streaming services. As many will no doubt continue to opt for free, ad-supported streaming, which Spotify also offers, but there should be steady growth in subscriptions as distribution in the music world goes more digital. As long as Spotify maintains its market share, it can ride this tailwind.
In the third quarter, Spotify's premium business brought in $2.5 billion in revenue with a gross margin of 29.1%. Annualizing those numbers, Spotify's premium business is bringing in approximately $2.9 billion in gross profit. Investors should keep watching the premium gross profit metric in the coming years to see whether this business is growing in value.
Ancillary businesses have tons of potential
As previously mentioned, Spotify has an ad-supported streaming segment. This has typically served as a funnel that channels listeners into its paid plans and hasn't directly contributed much to the business financially. However, it has started to pick up momentum in recent quarters due to Spotify's investments in non-music content. Right now, the big growth driver is podcasts. Spotify owns two podcast distributors (Anchor and Megaphone), multiple studios including the Ringer and Gimlet Media, and exclusive licenses to top shows like The Joe Rogan Experience and Call Her Daddy.
To make money from these investments/acquisitions, the company has started the Spotify Audience Network (SPAN), which helps dynamically connect advertisers to ad slots in podcast episodes. Growth in podcast advertising has helped drive Spotify's overall advertising segment revenues. In Q3, advertising sales grew 75% year over year to $365 million, well outpacing overall revenue growth of 27%. SPAN just launched in the spring of 2021, so it should have a long runway for growth ahead of it.
The company is also looking to move into audiobooks, as evidenced by its recent acquisition of audiobook distributor Findaway. It is unclear how Spotify plans to monetize audiobooks -- it could be through advertising, subscriptions, on-demand purchases, or a mix of all three. These ancillary businesses don't account for much of Spotify's overall top-line right now. But, based on how fast podcasts are growing in popularity, they could contribute significantly to its overall sales growth through the next five years and beyond.
Valuation is reasonable
For potential investors, one of the best things about Spotify stock now is that the market is discounting the company's long-term growth potential. Spotify currently has a market cap of $42 billion and trades at a price-to-sales ratio of about 4 based on its trailing 12-month revenue of $10.9 billion. It has low gross margins, so investors shouldn't expect it to trade at a sales multiple north of 10. But with the large tailwind in music streaming plus the optionality of its ancillary services, Spotify has a chance to more than double its annual revenues in the next five to 10 years.
It is hard to put a value on this potential growth. If Spotify continues to grow its revenue at a high rate for the next decade, it is likely that shareholders will get market-beating returns from the stock along with it.