Studying the Reflexivity of Valuations
A Case Study of What Ifs Utilizing Spotify
As multiples compress in the public and private markets, I continue to be fascinated by the reflexivity of valuations. When the stock price is going up, large uprounds or trading at 100x forward revenue is celebrated as an example of how employees will flock to this company taking over the world. When the stock price goes down, the narrative flips to how the company burned so much money trying to take over the world and is now sowing the sorrows of its harvest.
However, I do think there is something to learn about the reflexivity of valuations and I think Spotify is a great case study.
Reflexivity of Valuation in Action
From Wikipedia: Within economics, reflexivity refers to the self-reinforcing effect of market sentiment, whereby rising prices attract buyers whose actions drive prices higher still until the process becomes unsustainable. This is an instance of a positive feedback loop. The same process can operate in reverse leading to a catastrophic collapse in prices.
Similar things happen with talent, partnerships, PR, even customers to a certain extent. The more the stock price goes up, the more the company is all over the news which spikes the curiosities of more people leading to heightened interest in the company from various constituents.
However, valuation also has reflexivity in terms of company strategy. As valuations increase, companies have more need to grow into that valuation and also more latitude with which to push for growth which normally….leads to more growth in the org and projects attempted and so on.
The question then becomes how should we think about this reflexivity in terms of company strategy.
Spotify and Expanding the TAM
I am a huge Spotify fan not only as a customer but as a fanboy who admires their company culture and focus on serving all stakeholders (employees, shareholders, ecosystem participants, and social impact).
During the pandemic, an interesting thing occurred with Spotify. As people were stuck indoors, hours listened on Spotify grew rapidly, subscriptions grew as well, and the companies valuation expanded quite a bit (rightfully so).
Now what happens during the 2020-2022 timeframe is interesting. No longer is it enough for Spotify to have a great Act 1 (most incredible discovery engine in music ever), now they have to move with more urgency towards Act 2 when/if engagement moderates or even returns to pre-covid levels to justify valuations (both relative multiples and absolute enterprise value).
Starting in 2019, Spotify had already been making moves towards Podcasts and opening itself to other content. In 2020, the company unrolled these plans with outstanding velocity, shipping a podcasts product, launching exclusive podcasts (late 2020), podcasts subscriptions (2021), and then video podcasting (2022). First, Spotify is eating into Apple’s market share of podcasts (launching into podcasts), then it’s taking more share of consumer wallet (subscriptions), and finally going after some of Youtube’s share as well (videos).
This all helps to expand the TAM, justify the valuation, and cement the narrative around Act 2. And this all makes sense.
As we have now lapped covid, subscriber growth and engagement has slowed from covid peaks. However, now the company has an ambitious Act 2 that they have staffed a large team around and told shareholders is the future to further accelerate gross margins. In this case, reflexivity in some cases can constrain the ability of a company to adjust. Now with valuations going down and investors favoring more profitability over growth, it’s hard to pull back on that spend unless you collapse the valuation further and impact employee morale.
Here is where founders matter so much. Daniel Ek can truly focus the company on the long term and drive the company through market turbulence just as Jeff Bezos or Elon Musk or many other founders have done countless times.
BUT it still begs the question about strategy. What if instead of going after exclusive podcasts and subscriptions, Spotify leaned more heavily on their ML and classification strength to deliver a much improved podcast product compared to Apple to the market and did not branch out into an exclusives offering. I for one have used Youtube Music and Spotify both, and I can tell you the comparison is not even close. Spotify wins by miles with their recommendation engine.
By doing so, likely Spotify would not have as big an Act 2 story to tell. However, adding podcasts and focusing on better cataloging and making them searchable for a better end user experience while not moving into exclusives, would mean less employee costs, less marketing costs, all while accomplishing the same increased stickiness in the core product. Meanwhile, it allows for further optionality to assess other potential Act 2s whether spurred by large M&A or or big internal efforts in another vector.
I have no clue whether Spotify is doing the right thing or not. Daniel Ek is a stellar founder, has hired incredible people, and is likely pursuing the right vision. It’s more an interesting case study to think about how reflexivity of valuations can also drive strategy.
I guarantee you if Spotify told a story around simply making the podcast listening and ad experience better for constituents (i.e. being the “Spotify of Podcasts”) that would not have supported the same valuation as telling a story around becoming the “Netflix of podcasts” and owning original content thereby driving up gross margins as economics of scale kick in.
It’s an interesting lens with which to view company strategy in the future as it relates to valuation.
Note: BTW just to preempt any feedback on “Spotify is doing great” or “Spotify sucks” I want to be clear that 1) I think Spotify has amazingly smart people making the right strategic long term decisions and 2) I have no clue about whether it works out like AWS or fails like the Fire phone. I just picked them as a case study but could’ve picked almost any other company.