While today’s market is centering its attention on the technology sector, particularly on stocks that deal with the global growth and adoption of artificial intelligence, like NVIDIA Co. (NASDAQ: NVDA), other areas in the market warrant investor attention.

Subscription-based businesses will start to become more attractive amid uncertainty. That preference is being brought to life by stocks like Spotify Technology (NYSE: SPOT), which rallied by over 14.4% in the pre-market hours of Tuesday morning. The bullish reaction comes as the company released its second quarter 2024 earnings results, and needless to say, the numbers justified the double-digit rally.

Investors need to understand today that as Spotify’s financials expand, the compounding effects for future valuations are just getting started. Catching this household name before it becomes too big to ignore could be the key to outperforming the broader stock market in the years to come. Rather than blindly following the momentum, here’s what investors can focus on when breaking down the earnings release.

Spotify Stock's Main Drivers Point to More Upside

Reviewing Spotify's Q2 2024 earnings can be overwhelming due to its complex infographics and extensive corporate language across over 30 slides. Here's a straightforward summary of the key points and insights that investors can use to make informed decisions about Spotify's stock.

Starting with the most straightforward metric, revenue, Spotify reports an annual increase of 20% in sales to surprise Wall Street with another quarter of double-digit growth. However, not all revenue is equal, as investors will find out. There is advertising revenue and premium-based subscription revenue.

For Spotify, most revenue comes from subscription-based customers (it turns out people don't like to be interrupted when listening to music), and that's a good thing. As the stock market deals with the uncertainty of whether the Federal Reserve will cut interest rates before 2024, predictable cash flows are more important than ever.

Subscription revenues rose by 21% over the year, while advertising revenue grew by only 13%. Spotify's monthly active user growth is driving this divide. Premium subscriber growth was reported at 12% for the year and 15% for advertisement-based users, and that's Spotify's normal cycle.

Typically, users get a free taste of the platform and then realize they would be better off with a premium subscription, so seeing the divergence in growth is typical for this company. Investors can expect to see a healthy conversion rate from advertisement-based to subscription-based.

This momentum drove management to deliver an even bigger future, as the outlook for the next quarter also carries single-digit and double-digit upside in all the metrics that matter for the company's valuation.

Strong Financials Set Spotify Stock Up for Higher Valuations

After revenue has been accounted for, investors need to focus on other metrics that allow a stock to become a potential portfolio favorite. Spotify's consistent profitability is the best path to compounding and expanding valuation multiples.

Operating profits swung from a net loss of $247 million for the second quarter of 2023 to a net operating profit of $266 million in 2024, which is also higher than the first quarter of 2024 net operating profit of $168 million. The question is, how is this profit being translated into the business's free cash flow?

A year ago, Spotify generated net free cash flow (operating cash flow minus capital expenditures) of $9 million. While that was exciting, today's results are all the better at $490 million in free cash flow. Here's how rising free cash flow lays the foundation for future compounding.

As a company increases its cash balance through free cash flow, it can do a few things. The company will reinvest in itself. Now that Spotify is profitable, this reinvestment generates up to 5% return on invested capital (ROIC) rates, which are only expected to increase.

Besides reinvesting, management can improve the balance sheet by paying down debt to increase equity and book value. However, since Spotify's balance sheet is only 35.6% debt, that sounds like something other than a priority.

Lastly, management can reward investors through either dividends or share buybacks, funded by this free cash flow. Since the company is still going through its growth phase, it isn't likely that investors will see dividend payments any time soon, which is okay since share buybacks are typically a better way to get capital back as an investor.

Knowing this, analysts at Benchmark decided to boost their price targets on Spotify stock up to $405 a share, daring it to rally by 37.1% from where it trades today.