Excerpt

## TABLE OF CONTENTS

INTRODUCTION

1. CHAPTER 1: DISCOUNTED CASH FLOW VALUATION THEORY

1.1. Discounted Cash Flow Valuation

1.2. Cash Flows

1.3. Growth

1.4. Risk

2. CHAPTER 2: SPOTIFY BUSINESS MODEL

2.1. Spotify History and Business Environment

2.2. Mission, vision and values. The business model

2.3. From application, to platform, to global network

3. CHAPTER 3: ASSUMPTIONS

3.1. Expected revenue growth of 20% over the next five years

3.2. Reinvestment and R&D capitalization

3.3. Risks

4. CHAPTER 4: SPOTIFY DISCOUNTED CASH FLOW VALUATION

4.1. Revenues, margins and reinvestment

4.2. The cash flows

4.3. The value

CONCLUSIONS

BIBLIOGRAPHY

LIST OF FIGURES

LIST OF TABLES

LIST OF EQUATIONS

## INTRODUCTION

Digital multisided platforms have been drawing considerable attention in business and academic circles in the last years. Companies with digital platform business models or deriving much of their value from multisided platforms, such as Amazon and Apple, are the ones that have achieved the trillion dollar market capitalization milestone for the first time in history.

This paper attempts at measuring the value of a digital platform using a DCF valuation model. Discounted cash flow valuation relies on fundamental analysis, which is the analysis of a business’ balance sheets and financial statements, overall financial health of the company, and analysis of the competition and markets where the company operates. It also relies heavily on educated assumptions and future expectations about the business. While informed, these assumptions and expectations still are and will always be of a subjective nature.

The present work is an application of the discounted cash flow valuation model to Spotify Technology S.A. The aim of the thesis is to understand the theory of discounted cash flow valuation, to get acquainted with Spotify’s business model and history as a digital platform, to arrive at certain assumptions and expectations in terms of growth, reinvestment and risk and to apply the specific methodology in order to build the discounted cash flow valuation, also called DCF model.

This paper contains a theoretical model that describes one of the many possible future outcomes of Spotify as an investment. It is important to keep in mind that the assumptions driving this and any model are subjective, that past performance is not an indicator of future performance and that future performance cannot be forecasted with hundred per cent accuracy since the future is uncertain.

This paper is divided into four chapters: two of a theoretical and two of an empirical nature. The first chapter presents the basic theoretical requirements of a DCF model. The second chapter studies Spotify’s company history, market environment and business model. The third chapter explains the author’s assumptions and expectations in regards to the Company’s future financial performance. The fourth chapter contains the empirical discounted cash flow valuation model.

Chapter one deals with discounted cash flow valuation concepts of growth, reinvestment and risk and different approaches towards them. Chapter two describes Spotify’s history, mission, vision and values, with the Company having launched at a time of disruption in the music business during which users where moving to digital and away from paying for physical assets. It deep dives into its business model as a platform that enables value-creating interactions in a multiple-sided market. Chapter three outlines the assumptions driving revenue growth and reinvestments. It also compiles the main operational and strategical risks the Company faces. Chapter four explains in detail the actual application of the discounted cash flow model utilized to value Spotify Technology S.A.

## 1. CHAPTER 1: DISCOUNTED CASH FLOW VALUATION THEORY

This chapter introduces the reader to the theory of the discounted cash flow valuation or DCF model, which premise lays on the basis that the value of an asset is the present value of its expected future cash flows. It then presents the three main components that drive the value of a company. These components are the expected cash flows, the expected reinvestment in the company and its effect on the growth of cash flows and risk. Cash flows represent the company’s ability to create value for its stakeholders and they are what determines if a company is a potential attractive investment. Growth is a function of how much and how effectively the business is reinvesting in itself, therefore working towards securing continued cash flows into the future. Risk is the level of uncertainty towards the value and the success of a company as an investment.

### 1.1. Discounted Cash Flow Valuation.

The purpose of intrinsic valuation is to calculate the value of an asset or business based on its intrinsic characteristics, also called fundamentals. It is based on estimating the value of these intrinsic characteristics including tangible and intangible factors using fundamental analysis. Fundamental analysis looks at qualitative aspects of the business, such as business model and governance, as well as quantitative ones, by for example taking into consideration analyses of financial statements. This estimated value is then compared with the market value to determine whether an asset or business is overvalued or undervalued. The basic assumption underlying this approach is that markets are not perfect and that they correct their mistakes over time. Without accepting the assumption that markets are not perfect there is no purpose to the use of discounted cash flow valuation models. Intrinsic valuation is a core concept of value investors seeking to identify mistakes made by the market before they get corrected and benefit from potential investment opportunities.

Intrinsic valuation compiles a number of models for fundamental analysis that help estimate the intrinsic value of an asset or business. The most commonly used valuation method and the one selected to value Spotify Technology S.A. is the discounted cash flow model. The discounted cash flow (DCF) model aims at estimating the present value of future expected cash flows at a discounted rate adjusted for risk over the life time of the asset or business. Therefore, it is expected that the asset or business will generate positive cash flows at some point in time. Expected cash flows can be estimated back to equity or back to the business. Free cash flow to equity (FCFE) values the equity claim in the business, the rate of return investors would expect. Free cash flow to the firm (FCFF) calculates the value of the entire business and it is the approach used within this DCF. The reason why this approached was preferred is that by calculating free cash flows back to the entire firm we are taking into consideration bondholders and stockholders when considering the money left over for the investors, this approach also being referred to as “unlevered”, as it removes the impact of capital structure on the firm’s value, making the approach more holistic and different companies more comparable.

For an asset or business to actually have value, cash flows are expected to be positive at some point in time. The asset or business may report past or present negative cash flows within its balance sheets. However, valuation looks at the future, taking into consideration growth assets, potential of the business model, Company strategy, managerial decisions, state of the market… Within this DCF the decision has been to estimate free cash flows back to the firm (FCFF), as these are the collective cash flows to the business and they give us a wider view of the entire company. Because of this and to ensure consistency, FCFF have been discounted at the weighted average cost of capital (WACC). Cash flows to equity (FCFE) have been discarded on the basis of it being a limiting measure that would reflect only available cash to the equity shareholders after the Company has paid all expenses, reinvestment and debt.

As stated before, a DCF model aims at estimating the present value of future expected cash flows at a discounted rate adjusted for risk over the life time of the asset or business. There are two fundamental ways to adjust for risk: adjusting the cash flows or adjusting the discount rate. When adjusting cash flows directly expectations should be replaced with certainty equivalents, also called guaranteed cash flows; then discount at a risk free rate. When adjusting the discount rate we take into consideration expected cash flows and adjust the discount rate for risk. Within this DCF the decision has been to adjust the discount rate for risk by adding the cost of capital on top of the risk free rate. In this case the cost of capital is given by the WACC, for consistency, since cash flows are being discounted back to the business, not to equity. The weighted average cost of capital is the average return a company expects to compensate all its different investors. The weights are the fraction of each financing source in the company’s target capital structure.

A valuation is to be estimated over a specific period of time, let it be the life time of the asset if known, a specific growth period or perpetuity, until what is called the terminal value. There are different approaches for arriving at terminal value. When the life time of the asset is known, and the asset is separable and marketable, we use liquidation value. When the life time of the asset or business is not known or it is expected to grow into perpetuity, we use a stable growth model. A stable growth model attempts at valuing the business as a going concern and it requires to make assumptions as to when the firm will start growing at a stable rate and the excess return that it might earn within that period. Within this DCF the decision has been to value Spotify over a ten year horizon and assume stable growth from that point on, arriving at a terminal value in year ten.

Equation 1.1. Value of an asset as the present value of its expected future cash flows.

Abbildung in dieser Leseprobe nicht enthalten

Source: Damodaran, A. (2012). *Investment valuation: Tools and techniques for determining the value of any asset* (Vol. 666). John Wiley & Sons.

Aswath Damodaran synthetizes DCF within the equation above: the value of an asset being the present value of its expected cash flows, discounted at a rate adjusted for risk and over a period of time. For a DCF to deliver a reliable estimation of value consistency needs to be maintained across the model. The three main components within a DCF are the expected cash flows, the expected growth in these cash flows and the uncertainty around the actual delivery of these cash flows. A DCF requires assumptions about all three variables, taking into account these are interconnected and need to be consistent with one another. For example, it would be odd to assume a high growth firm with low risk and low reinvestment. Consistency is key to the reliability of a value estimated through DCF.

### 1.2. Cash Flows.

The DCF is a valuation method used to evaluate the attractiveness of an investment opportunity by estimating the present value of expected future cash flows at a discounted rate. Cash flows are the amount of cash and cash-equivalents being transferred into a business. At the most fundamental level they represent the company’s ability to create value for its stakeholders. Therefore, they are the first thing to be taken into consideration when an analyst performs a DCF valuation. Assessing the quantity, quality and level of certainty of expected cash flows with accuracy is one of the most fundamental objectives of any valuation. Financial information in regards to cash flows can be found within the cash flow statement of any given company, which generally reports operating, investing and financing cash flows, essential to assess a company’s liquidity and overall financial performance.

Table 1.1. Reconciliation of EBITDA to net loss attributable to owners of the parent and reconciliation of Free Cash Flow to net cash flows (used in)/from operations activities in million euros.

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Source: own elaboration, based on Spotify Technology S.A. (2019) *Annual Report*. United States, Securities and Exchange Commission.

In order to estimate expected cash flows to the entire business an analyst has to take into consideration operating income and reinvestment needs. The operating income of a business can be found within the financial statement and it is also called EBIT. EBIT stands for Earnings Before Interest and Taxes, and it is commonly used to analyze and compare profitability between businesses regardless of financing and accounting decision. Operating income or EBIT is simply revenue minus operating expenses. The revenue is the income generated from the sale of goods or services, or any other use of capital or assets associated with the main operations of an organization before any costs or expenses are deducted. Reinvesting is taking some of those earnings and putting them back into the business, aiming at future growth. The reinvestment rate can exceed 100%, if the firm has substantial reinvestment needs but it can also be less than zero, for firms that are divesting assets and shrinking capital. To arrive at free cash flows to the firm we need to discount reinvestment needs from operating income. In firms with negative earnings due to being young growth companies reinvestment is based upon estimated revenue growth, targeted operating margins and estimated sales to capital ratio.

Table 1.2. Consolidated Statement of Operations Data and Consolidated Statement of Cash Flows data in million euros.

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Source: own elaboration, based on Spotify Technology S.A. (2019) *Annual Report*. United States, Securities and Exchange Commission.

In order to estimate reinvestment in companies with positive earnings an analyst has to take net capital expenditures and investment in working capital into consideration. Net capital expenditures are the difference between capital expenditures and depreciation. Capital expenditures are funds spent for tangible or intangible assets that will be used for more than one year in the operations. They refer to the purchase, improvement or maintenance of long-terms assets to improve the efficiency of the operation. Capital expenditures typically include purchase of buildings, machinery and equipment; though depending on business model expenses such as R&D and marketing could and should be considered CAPEX for financial purposes. Depreciation is the reduction in the value of an asset over time, and also an accounting method for allocating the cost and declines in value of an asset over its useful life. Working capital refers to the funds invested in the current assets of a firm, it is the money available to fund a company’s day to day operations.

Reinvestment can be estimated for companies with negative earnings too. A company may have negative earnings due to temporary, long-term problems or just because of where they are within their life cycle. Companies with negative earnings can still be valued, as long as positive earnings are expected at some point in the future. In order to estimate reinvestment for young growth companies and growth firms early in their life cycle, an analyst would take into consideration estimated revenue growth, targeted operating margins and sales to capital ratio. The sales to capital ratio is an asset utilization measure and it indicates how efficiently a company turns its short-term assets and liabilities into sales. It represents the amount of sales for every dollar of the working capital used. The sales to capital ratio can be estimated using the Company’s data and the sector average.

The sales to capital ratio is calculated by dividing revenues by working capital, revenues being the income generated from operations before any cost or expense has been deducted. Working capital is simply current assets minus current liabilities. Therefore, in order to calculate a Company’s sales to capital ratio an analyst would go to the financial statement and divide revenues by the book value of equity, which is the sum of the Company’s current assets, plus the book value of debt minus cash and marketable securities. Marketable securities are debts to be redeemed within a year, financial instruments that can easily be converted into cash.

Equation 1.2. Reinvestment ratio.

ReinvestmentT = Change in revenuesT / (Sales / Capital)

Source: Damodaran, A. (2011). *The little book of valuation: how to value a company, pick a stock and profit*. John Wiley & Sons..

Earnings and / or cash flows may be positive or negative at a given time during the life time of the Company. Past and present positive or negative earnings or cash flows are not necessarily an indication of future performance. However, for a company to be considered an investment opportunity there has to be an expectation that it will generate positive earnings and cash flows at some point in the future. The longer the company generates negative cash flows, the higher and more explosive the revenue and earnings have to be expected for it to be considered a good enough investment. Positive cash flows indicate a company’s liquid assets are increasing, enabling it to repay debt, reinvest in its own business, return money to stakeholders and withstand financial distress more easily. However, liquidity might also be an indication of poor performance if, for example the origin of such cash flows is unsustainable levels of debt or dissolution of long-term assets without further reinvestment in the Company.

### 1.3. Growth.

Growth is one of the three main components of any DCF. It refers specifically to calculating the expected growth in the future cash flows of a firm. It can be estimated based on historical growth, the opinion of analysts or based on fundamentals. Historical growth is a good indicator of how the firm performed in the past. However, it is not a reliable indicator of future performance. The opinion of analysts is often used in relative valuation, which is a method that compares a company’s value relative to that of its competitors. Calculating fundamentals is considered to be the most reliable and efficient way to estimated growth by value investors. By fundamentals we refer to estimating growth based on the company’s business model, how much it reinvests in itself and how efficiently it does it.

The growth in revenue for a business is considered to be fundamentally a function of two decisions: how much to reinvest back in the business and how efficient this reinvestment is expected to be. The simplest proxy to identify how much the firm is reinvesting back in itself is the reinvestment rate, which is a combination of net capital expenditures, such as acquisitions, R&D… and the change in working capital. Working capital is calculated by subtracting current liabilities from current assets. Adding net capital expenditures to the change in working capital and dividing that by earnings before interest gives you the reinvestment rate for the company. In order to understand how efficiently the firm is reinvesting back in itself an analyst would look at the Return on Invested Capital (ROIC). The ROC reflects the operating income before taxes divided by the book value of equity and book value of debt adjusted for capitalization minus cash and marketable securities.

Equation 1. 3. Expected growth in operating income.

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Source: Damodaran, A. (2008). The origins of growth: past growth, predicted growth and fundamental growth. *Predicted Growth and Fundamental Growth (June 14, 2008)*.

The reinvestment rate indicates how much of the after tax operating income goes back into the business. The return on capital rate indicates how well the Company is using reinvestment to generate returns. The return on capital rate uses the book value of assets and securities, as it is entered by accountants in a firm’s books. A financial analyst would adjust those figures for market value. For example, the book value of EBIT would be adjusted for extraordinary or one-time expenses or income and it would be normalized for cyclical earnings; the book value of equity would factor in capitalization of expenses such as R&D or marketing; and the book value of debt would factor in capitalized operating leases. The higher the ROC, the more efficiently the Company is generating money. Changes in ROC over time can be calculated through the efficiency growth ratio. A Company that is generating a return on capital of x% on its existing assets may expect to either increase this return by y% points next year or decrease it by z% points. The main difference between growth from new investments and the efficiency growth is that the first one is often sustainable and longer term, whereas the latter is often short term and transitory.

Equation 1. 4. Return on Capital.

Abbildung in dieser Leseprobe nicht enthalten

Source: Damodaran, A. (2012). *Investment valuation: Tools and techniques for determining the value of any asset* (Vol. 666). John Wiley & Sons.

Companies with past or present negative earnings are considered a good investment opportunity, as long as positive cash flows can be expected at some point in the future. In order to generate positive earnings the company has to grow, and in order to grow it has to reinvest in itself. But how can a company with negative earnings reinvest in itself? What can it reinvest in itself, taking into account it is generating losses instead of profit? In this case a financial analyst would first estimate a revenue growth rate for the company, taking into account market potential and competition. Secondly an analyst would estimate targeted operating margins looking at industry averages and historical data. Last but not least, an analyst would estimate the capital that needs to be reinvested to generate the estimated revenue grown and the expected margins. This is the sales to capital ratio.

Table 1. 3. Spotify reinvestment needs taking into account estimated growth and targeted operating margins.

Abbildung in dieser Leseprobe nicht enthalten

Source: own elaboration.

Estimating growth we obtain the expected revenue, operating margin gives us the operating incomes and the third step, the sales to capital ratio gives us reinvestment and eventually cash flows to the firm. By taking a fourth step and calculating the return on capital we can get an idea of how accurate our valuation might be. A return on capital that seems too high or too low in comparison to industry averages could be an indicator of a too high or too low sales to capital ratio. Naturally growth is expected to decrease over time, the bigger a company gets the more difficult it is for it keep growing. Operating margins are expected to increase as the company becomes more efficient in generating and delivering value to the market. Reinvestment and ROC would vary depending on the firm’s strategies and stage in the lifecycle.

Companies are not expected to grow forever and this is to be taken into consideration when performing a DFC valuation. An analyst might assume the business would come to an end and then calculate liquidation value. We might also assume the business would continue to grow into perpetuity, which is called a going concern. Since we cannot estimate cash flows forever, we estimate them for a growth period and then arrive at terminal value, also called stable growth. Terminal value is the constant rate at which the company would continue to grow into perpetuity. The stable growth rate should not exceed the growth rate of the economy, as it would be unlikely to happen in reality. In order to assume when a firm will achieve growth rate we should look at its size, at its current growth rate and the market. The stronger and more sustainable the competitive advantages a company has, the longer its growth period can be. It is important to look at the ROC the company is expected to generate into perpetuity, which should be compared to the cost of capital and will be affected by the competition among other factors.

### 1.4. Risk.

Traditional definitions of risk in business valuation refer to the possibility of a financial loss or drop in asset value. In modern portfolio theory it is the volatility, the standard deviation of shares’ prices what defines the risk, reason why for the emergence of diversification strategies. However, risk is also seen as an opportunity, so long as the return compensates the investor for bearing the risk. In discounted cash flow valuation, the value of an asset equals the expected value of its future cash flows over a period of time, adjusted for risk. There are two fundamental ways to adjust for risk. One is adjusting the cash flows for risk; the other one is adjusting the discount rate. The discount rate refers to the interest rate used to determine the present value. The appropriate discount rate depends on the asset being valued. For example, when investing in standard assets, like treasury bonds, an investor would use the risk-free rate as the discount rate. However, when assessing the value of a business, an investor may use the WACC, as stated above.

Aswath Damodaran teaches that the best way to estimate how risky an investment may be is by asking ourselves how risk may be perceived by its marginal investors. A marginal investor is a representative investor whose actions reflect the belief of those people who are currently trading a stock. The marginal investor owns the majority of the stock and therefore influences or even determines its price. Most risk and return models in finance are based on the premise that the marginal investor is a diversified investor. Therefore the risk they would see in an investment is the risk that it adds to a diversified portfolio. The most common risk and return models in financial investment are the capital pricing model or CAPM; the arbitraged pricing model or APM; the multi factor model and proxy models. In CAPM the risk of an investment is the risk that it adds to the market portfolio. The market portfolio is one that includes every single asset available in the market. In APM and multi factor models are based on statistical and economic factors, respectively. Proxy models take historic market data to make and apply generalizations about the market. For example, historic market data tell us smaller companies tend to deliver higher returns than bigger markets, and we can use this as a proxy. All risk and return models start with the risk free rate as an input.

Here is how to calculate the risk free rate. For something to be risk free the entity issuing the security cannot have any default risk, it has to be default free. For something to be risk free there can be no reinvestment risk. Reinvestment risk is the probability that an investor will be unable to reinvest cash flows at a rate comparable to the current investment’s rate of return. Traditionally, financial investors would use a long term government bond rate in the currency of their interest as a risk free rate. For example, in order to estimate a US dollar risk free rate, an investor would use US government bond rate, choosing the longest term possible, such as ten. This is the risk free rate used in Spotify’s valuation, which was 2,85% at the time of the IPO. It has currently dropped to 2,65%. To arrive at the discount rate the risk free rate has been completed with the weighted average cost of capital. The WACC is the average rate a company expects to pay to finance its assets.

The discount rate is to be consistent with the DCF as a whole. For example, when valuing a company, if cash flows are being discounted back to the whole business then we have to make sure the discount rate is the cost of capital. The rationale behind is that the cost of capital is the return necessary to finance the whole business, including cost of equity but also cost of debt. If we were calculating cash flows back to the whole business but discounting at the cost of equity, then we would be missing the cost of debt, when we know nowadays the most common mix of financing is debt and equity. If cash flows were discounted back to equity, then the discount rate would be the cost of equity only. Equally, when valuing a company in nominal values, adjusting for inflation, the discount rate is also to be nominal and in the exact same currency that measures the whole exercise. If the DCF were real values then the real discount rate would have to be used.

The equity risk premium refers to the excess of return that investing in the stock market provides over a risk free rate. This is the premium an investor would demand, over and above the risk free rate, for investing in risky assets. The excess compensate investors for taking on relative risks. The size of the premium varies depending on the level of risk in a particular portfolio but also on market fluctuations. As a rule of thumb, high-risk investment are compensated with higher premiums. The equity risk premium can be forecasted based on historical data, based on market analysts’ assumptions or both. One way of calculating the equity risk premium is following an equity volatility approach that draws on the standard deviation of two equity markets, a base market, usually the US, and an emerging one. This country equity risk premium is based upon the volatility of the market in question relative to the base market. The total equity risk premium for the emerging market would then be the base market risk premium multiplied by the emerging market risk premium divided by the equity of the base country.

The corporate equity risk premium would be calculated in a similar fashion, assuming first that every Company in the country is equally exposed to the country risk. This is what we are assuming when we take the local government’s long term bond rate as the risk free rate. The next step is assuming that a Company’s exposure to country risk is similar to its exposure to other market risk. The last step is treating a country risk a separate risk factor and allowing firms to have different exposures to country risk based upon different factors, such as proportions of revenue coming from non-domestic sales. When estimating country risk premium exposure the analyst may follow a location based approach or an operation based approach. The location based approach takes into consideration the Company’s country of incorporation. For example, a Swedish Company would be assumed to be exposed to the Swedish country risk premium and unexposed to emerging market risk. The operation based approach computes the country risk premium of a Company as the weighted average of the country risk premiums of the countries where it operates.

Coming back to traditional definitions of risk referring to the uncertainty and the possibility of a loss of value in the investment, there are many other factors to take into consideration when valuing a business, such as macro and micro economics factors, continues and discrete risks and even errors of estimation. Macroeconomic risks are related to macroeconomic factors such as economic output, unemployment, inflation… While microeconomic risks deals with decisions by individual consumers, such as demand, the fluctuation in the price of a product... Continues risks are those occurring continuously, such as changes in interest rates or economic growth, and they affect value as they happen. Discrete risks are one-off instances, such a terrorist attack, or risks that lie dormant for periods but show up at points in time, such as the nationalization of a company. Estimation uncertainty reflects the possibility that the analyst could have just got the model wrong or estimated incorrect inputs. If we take Spotify’s IPO as an example, the company lists risks related to their business and their operations, such as potential declines in user base growth, unsuccessful agreements with third-party companies or the inability to decrease operating losses and start generating sufficient revenue. All these risks are to be carefully considered by the prospective investor before making a decision.

**[...]**

- Quote paper
- Olaya Gesteira (Author), 2019, Discounted Cash Flow Valuation of Spotify, Munich, GRIN Verlag, https://www.grin.com/document/538406

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