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Are Investors Overvaluing Spotify?

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The Wall Street Journal says Spotify could be overvalued

Last month, the Wall Street Journal reported that Spotify was gearing up for a new round of funding that would raise $400 million and hike its value up to $8.4 billion. The article identifies Goldman Sachs (GS) and an Abu Dhabi sovereign wealth fund as those investing in Spotify.

A more recent May 3 report from the Wall Street Journal suggests that investors might be overvaluing Spotify. The report looks at a number of parameters used to model Spotify’s valuation and concludes that Spotify could now be a risky investment.

Spotify is indeed highly valued. At $8.4 billion, its value is more than double that of Pandora (P), which is currently valued at $3.7 billion.

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Why Spotify is valued so highly by investors

As the chart above shows, Pandora made a $30 million net loss in 2013 compared to Spotify, whose net loss was $79.6 million. The main reason for the losses in this industry are the high royalty fees that companies must pay music labels to access songs. This is where Apple (AAPL) wants to step in and streamline the music-streaming market. Apple is negotiating with music labels to lower prices in an effort to pass savings on to its music-streaming service users.

More transparent business model

Despite netting greater losses and having a smaller market share than Pandora in the Internet radio space, Spotify could fetch better valuations because of its different business model. Pandora generated about 72% of its revenues from advertising and the rest from music subscriptions as of 1Q 2014. Spotify earns the bulk of its revenues from subscriptions, and only a small amount from advertising.

According to Spotify, in January 2015, it had about 45 million free users and 15 million users paying $9.99 per month for advertisement-free music subscriptions. Investors like the subscription model better than the advertising model because it offers more certainty about a company’s future revenues and profits.

International expansion

Spotify is aggressively expanding its reach in a number of international markets. It recently entered Canada and now has plans to enter Japan (EWJ). Earlier, it had plans to enter Russia (RSX), which it decided not to pursue due to deteriorating economic conditions there.

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