A prediction that Upstart Holdings' (UPST 20.96%) stock price would grow by tenfold in 10 years may not sound all that insightful, depending on the point of view. With the stock trading down 93% from its all-time high, a 10x gain wouldn't even get it to its original peak.
So let's expand the speculation and say that Upstart offers a loan evaluation tool that could indeed be a game-changer in the industry. That tool, and the company's efforts to pursue larger loan markets, means a 10x price gain could be just the beginning for this consumer finance stock.
Upstart's path forward
Upstart centers its business model around an artificial intelligence-driven loan evaluation tool. Instead of acting as a bank, it evaluates credit risks for prospective borrowers and then connects those borrowers with a partnering financial institution that generates the actual loan. Upstart collects a fee from the partnering bank for evaluating the loan candidate.
Its AI-based evaluation model considers many more variables than the well-established FICO credit score from Fair Isaac (FICO 3.69%), and it claims to be far more accurate in assessing credit risk. Upstart has approved about 73% of its loans through an instant and fully automated process. That automation may partially explain its rising popularity among loan applicants as well as banking partners. The company partnered with 71 banks as of the end of the second quarter, up from just 25 in 12 months.
Upstart's lower loan default rates have everyone talking about Upstart stock. According to company data, defaults among applicants who earned an A+ rating from Upstart (its top rating) did not vary significantly regardless of their FICO score. But default rates among applicants getting Upstart's lowest grade, E-, were high for applicants, even if they had a high FICO score. This indicates that Upstart could approve more loans without increasing default risk because it was better at grading an applicant's ability to pay.
Upstart is expanding its potential markets
Moreover, if rising popularity does not drive 10x growth, pursuing larger markets may. Upstart got its start by evaluating borrowers for fixed-rate personal loans. That's a $129 billion market, according to TransUnion.
Upstart has since ventured into auto lending, which TransUnion data estimates is a $770 billion market, nearly six times the size of the personal loan market. Within less than two years, 640 dealerships had adopted Upstart's platform (as of Q2), more than triple the number reported at the same time the previous year.
Additionally, Upstart entered the $644 billion small-business loan market in June, and it plans to venture into the home loan market, a market TransUnion values at $4.2 trillion. As it takes a more central role in the lending process, it could dramatically raise its fee income, sending profits -- and likely the stock -- much higher.
Be aware of Upstart's business risks
Despite the prospects for gains, investors need to stay aware of the risks. Upstart billed itself as a loan evaluator rather than a money lender. However, investors soured on the stock as it temporarily held loans on its balance sheet amid its move into new loan markets. Moreover, despite a promise to remove such loans from the balance sheet, it actually increased the loan total on the balance sheet in the next quarter. Upstart held $624 million in loans at the end of Q2, up from $598 million in Q1 and $252 million at the end of Q4.
An additional risk involves its client base. Cross River Bank originated 52% of loans on the platform in the first half of 2022. A second bank accounted for 37% of the loan volume during the same period. That's 89% of its loan volume being tied to just two banks. In the same period one year ago, two banks made up a combined 92% of loan volume, meaning it is not unwinding a heavy dependence on two banks significantly.
Another challenge comes from the economy itself. The Federal Reserve is on a mission to raise interest rates in an effort to quell rising inflation. Higher interest rates tend to reduce the number of loan applicants. This will likely reduce Upstart's revenue from loan evaluation as consumers take out fewer loans.
Is Upstart stock a buy?
Upstart's business is working to manage some significant risks, and risk-averse investors should probably pass on this company. However, for all of the company's problems, its loan-evaluation model can approve more loans at a lower risk than the established FICO score. If Upstart can persuade more banks to use its model instead of the FICO score, a 10x gain in 10 years or less may be just the beginning of the growth potential for this stock.