These 2 Stocks Look Ridiculously Overvalued. Here's Why They're Not

Investors don't want to buy a stock that's too expensive. But knowing what's overvalued or undervalued in the stock market is complicated. There are plenty of handy valuation metrics that people like to use, but using these without contextualizing them can cause misunderstandings.

Motley Fool contributors Matthew Frankel and Jon Quast believe both property-technology company Latch (LTCH -10.00%) and personal credit company Upstart Holdings (UPST 3.90%) look expensive by valuation metrics but actually aren't overpriced. In this video from Motley Fool Live, recorded on Sept. 9, they explain their rationale.

Jon Quast: First, I'm going to talk about a company called Latch. Latch is absurdly overvalued if you look at traditional valuation metrics, but I think it's one of the greatest deals in the market.

It has a price-to-sales ratio of 68, that is nosebleed by any metric. It also has negative gross margin at the moment. Latch is a smart lock device company, and they are literally spending more on these smart locks than what they sell them for. They are taking a loss right out of the gate with these things. On the surface, that makes Latch as a $1.9 billion company look absurdly overvalued.

However, you've got to understand the context with Latch. There's a big difference for Latch between revenue and bookings and when they sign deals with these apartment complexes, these property owners, it's up front typically, on a new build and these products are some of the last to go in the building. They've got to build the building for six months to a year, to 18 months, they're building these properties. They already have a contract in place that Latch is going to be installed. But they don't get to recognize that as revenue until the device is actually put in there.

There's a big disparity between the bookings and the sales. Sales are actually a little bit behind expectations right now because there is a slowdown in construction. But bookings are ahead of expectations, because they are actually signing more deals than they thought they were going to.

The hardware does have a negative gross margin, but Latch also has a growing software business, and the software side of the business has better than 90% gross margins. Over the next few years, the software should make up more than double the revenue of the hardware, so all of a sudden the margin profile is going to completely flip on its head with Latch.

You look at this, the revenue is going to come in, they have these really high-visibility revenue streams that six year contracts. It's going to come in. And it's going to flip on its head from hardware revenue to software revenue, so the margins are going to completely look different. This company is on track to have $249 million in annual free cash flow by 2025. That means that it currently trades around 7.5 times its forward free cash flow. That is quite a bargain if you believe that management can go out there and accomplish this and if you're willing to hold for the next four years, which we believe investors should.

Matt Frankel: I like that Latch is pivoting to office buildings. Latch actually recently signed a customer, that you might have heard of, called the Empire State Building, to [laughs] provide security for its offices and it's just really impressive early results with that one.

Quast: Yeah, I was so excited about that. I actually made Latch a core position in my portfolio recently.

Frankel: I had the opportunity to talk to their CEO a little while ago on Industry Focus and you just get the sense, this is his baby. Former Apple executive founded the company. I can't say enough good things about Latch. Not a cheap stock, that's the worse thing I could say about it, which is the reason we're talking about it right now.

The one I wanted to talk about is one of our favorites of The Motley Fool, it's a favorite among mine and a lot of our analysts on the team, is Upstart, ticker symbol UPST. Upstart, their early results to say they've been impressive, would not be doing it justice. Upstart went public at $20 a share in December, it's trading for about $265 as I'm talking. It's already trading at 13 times its IPO price. By any traditional valuation metric this looks very expensive.

Upstart, unlike a lot of the growthier companies we talked about, is a profitable business. But on a price-to-earnings basis, it has a multiple of 403 times earnings, 403. The value investor in me consider anything over 20 to be expensive. It trades at 46 times sales, so it's cheaper than Latch on a price-to-sales basis. But it's still a very expensive company. But this is why we say you need to take into account some of the other metrics.

Upstart is growing its revenue at an unprecedented rate. It increased its revenue by 61% in the second quarter, not compared to a year ago, compared to the first quarter, so on a quarter-over-quarter basis, it's growing at more than 60%. Revenue's up tenfold from a year ago. And it has a massive addressable market opportunity. This growth is proving that it can grow into its addressable market.

It's just launching in the auto industry. It's just starting to ramp up its auto lending capabilities. Specifically in auto loan refinancing, which it could do a much better job of for subprime borrowers than the existing methods. There is over $1.3 trillion of auto loan debt in the United States. Upstart did $2.8 billion of loan volume last quarter. That's a lot of room to grow and they're really showing that they can grow into it.

Another point I'd like to make, and I'm sure Jon would agree with me on this, companies like the two we're talking about, a high valuation can be a big competitive advantage, especially when it comes to raising capital. Upstart can raise $1 billion dollars of capital and barely dilute shareholders. Most of its competitors, especially traditional lenders, could not. With Latch traditional smart-home hardware makers generally cannot raise capital at the valuation. They could have if they wanted to. They don't need to, they just got a bunch of money from their SPAC. But in a lot of cases, I've said before, Tesla's biggest competitive advantage over auto rivals is its valuation because it can raise capital for nothing. It's not just about the numbers, valuation can be an advantage, too, even if it's high.