Spotify has joined the $1 billion club, according to numerous media reports. Russian investor Yuri Milner, who has put money into Facebook, is said to have invested $100 million in Spotify through his Digital Sky Technologies fund. That investment is said to value Spotify at $1 billion.

That's an incredible valuation for a company in a high-risk area where the two biggest companies (Apple and Amazon) only dabble in music. Pure-play digital music companies tend to have a more difficult time competing for market share and staying in business.

If you read my Spotify review in November (subscription required), you know I think Spotify is an excellent service. But whether or not Spotify is worth $1 billion is another issue. Even a great product can have a tough time creating a sustainable business.

What goes into this thinking behind a $1 billion valuation? A number of assumptions are built in:

-- The market for subscription services is far larger than the current number of subscribers implies. Revenue would need to come from adding more markets (such as the U.S.) and getting deeper penetration in the markets in which it operates. Spotify has about 750,000 subscribers (the last number given by the company). At $12 per month (a rough estimate that blends mobile and PC subscriptions), subscriber customers are worth $108 million per year. Advertising accounted for 40% of revenue in 2009, so add another $73 million for total revenue of $181 million. That's a big jump from the £11.3 million (U.S. $18.2 million) the company reported for 2009 revenue, but let's use these numbers just for illustrative purposes. Now, at a $1 billion Spotify is valued at 5.5x revenue (and that is a very generous estimate of annual revenue). That implies very good future growth from recorded music, tickets and/or merchandise as well as good operating margins.

-- Spotify will negotiate better licensing rates in the future. Most people consider today's on-demand music royalties and profit-sharing deals to be rather crippling. But a company crippled by royalty obligations probably isn't worth $1 billion. A company with very good margins is worth $1 billion. And by the way, if Spotify gets better licensing deals then so will its competitors.

-- Apple's 30% tax on in-app subscriptions won't be a problem (or become a problem after the deal was signed). Normally reducing a large part of a company's revenue by 30% would hurt the valuation of a company. But there will be ways around dealing with Apple. In Europe, for example, Spotify is already working with broadband providers and mobile carriers to allow subscribers to pay for the service through those companies' billing processes.

-- Investors will have an exit in next five to ten years that will justify a $1 billion valuation. Will another company buy Spotify for over $1 billion? Will it be able to raise $1 billion in an IPO? One of those two events is expected to happen (unless another investors buy the shares on the secondary market). Investors put money into a company with the intention of getting a return on their investment. In order for that to happen, they need to have an exit. Would another company buy Spotify? It's very possible. Best Buy acquired Napster in 2008 - although it paid $121 million for a service with a similar number of subscribers as Spotify has today. And as Pandora will prove, a digital music company can have an IPO - if it can rein in costs, be a market leader and have a high rate of growth.

Those are some big assumptions that are baked into the $1 billion valuation. For every bullet point that does hold true, Spotify's value drops. If you don't think that there is a huge potential market for subscription services, for example, then you probably don't think the company is currently worth $1 billion. If you think Spotify's best hope is its free, ad-supported services, you're effectively saying the company's revenue potential is not as great as a $1 billion valuation implies.