The stock market has taken everyone for a wild ride in 2023, considering the swings felt after most participants were driven by fears of a coming recession, and some even sold all their stocks altogether once the FED seemed more determined than ever to continue on their interest rate hike path.
It is no secret that the technology stocks sector of the economy is mainly responsible for the new 52-week highs seen in the S&P 500. However, there is a wide outperformance gap when you look at the Technology Select Sector SPDR Fund (NYSEARCA: XLK), how big? Try 29.7% year-to-date.
In a previously bearish environment, job cuts would have sent a stock plummeting and scared some investors. In today’s bull run, Spotify Technology (NYSE: SPOT) has rallied by 11.3% in the past week after announcing its own wave of job cuts.
What a time to be alive! This strategic restructuring has even led analysts to boost the stock, but more on that later.
Suddenly a winner
When you spread out the technology sector, namely the broadcasting radio and television industry, there are only three players that are worthy of taking a second look at. First in line is Spotify, grabbing all the attention today and reaping all the rewards from price action and analyst ratings.
The market has voted which of these is its favorite, leaving breadcrumb evidence behind in the form of ratios. You see, by tracking a valuation metric like the forward price-to-earnings ratio, you can gauge where the markets are valuing the next twelve months of earnings for a given stock.
On average, this radio and television industry trades at a 37.2x forward P/E, your new benchmark against which to compare stocks. Roku is definitely the cheapest, considering the company has yet to make a net profit per share, so maybe it won’t be the best one to compare Spotify against.
Taking Netflix as a respectable competitor, who is not only bigger but also counts with a longer operating track record of success, this one trades at a 28.6x ratio, which happens to be a discount of 23.2% to the industry. Value investors may be raising an eyebrow at this, but wait a bit.
Spotify is trading at a massively superior 127.6x forward P/E, and before you term this as an obscene valuation, keep in mind that it must be ‘expensive’ for a reason. What is the reason? It’s actually simpler than you think.
More upside than meets the eye
So, markets are willing to overpay for Spotify stock, and they are all betting on one thing. The radio and television industry is expected to grow its earnings per share at an average rate of 52.6% for the next twelve months, so why Spotify and not Netflix?
Netflix analysts are projecting EPS growth of 31.8% for next year, which is below the industry average and thus a justification for markets to value it at that 23.2% discount to the industry. It doesn’t get simpler than that.
On the other hand, Spotify is predicting a massive jump of 172.6% in EPS for the next twelve months, which is enough of a factor to make markets overpay for the stock, and rightfully so.
What is giving markets confidence that the company will in fact pull off this EPS jump is coming from management’s initiative to run a ‘leaner’ shop. You see, Spotify’s operating margins stand at roughly 0.9% as of the latest quarter financials.
However, analysts are betting that this margin will expand by a decent amount in the coming quarter due to the job cuts and restructuring being implemented today. A little change will really go a long way in this case.
The beauty of only having $0.33 EPS in the past quarter is that even a five-cent boost will represent a 15.0% improvement, so management only needs to move the needle slightly in the right direction to bring about a stock rally.
Analysts at KeyCorp (NYSE: KEY) and Morgan Stanley (NYSE: MS) have upgraded the stock significantly in the past couple of days. At KeyCorp, price targets have risen to $255.0 a share, implying a 31.3% upside from today’s prices.
Morgan Stanley analysts see a $230.0 valuation, which seeks to boost the stock price by as much as 18.5% from where it can be bought today.
Don’t fight the trend, and don’t look to fight the market’s reasoning because when it comes to their view on Spotify stock, the playing field is definitely dominated by bulls.