Whenever consumers applies for a loan, they worry about one thing: their credit score. A few points higher or lower could make a big difference in the interest rate, which could be a lot of money over the life of a loan. Especially for those starting out, a good credit score can be challenging to achieve, even with a flawless record.
To better assess risk, Upstart (UPST 3.90%) created its artificial intelligence (AI)-powered model, which it believes better assesses creditworthiness than Fair Isaac Corporation's (FICO 3.26%) FICO score. If you judge the product solely by the company's share price, you may think it's a flop, with the stock down nearly 95% from its all-time high. However, I think this is a misguided way to judge the business, and its stock may also be undervalued.
A better credit assessment model
Upstart claims it can better assess risk than a traditional FICO model, and it provides this graphic to back up its claims:
Image source: Upstart.
You can see that borrowers with great FICO scores (700 or above) with a terrible Upstart risk grade (E-) default on 10.2% of their loans annually. That means an unsuspecting lender may give these borrowers the best rate when they should be charging them a premium due to their risk. Overall, Upstart's model does a much better job identifying risk than a FICO score.
Upstart was founded in 2012, which means its AI model has yet to experience a high-interest rate and recessionary environment. This unknown could spell trouble for the business, as it could be incorrectly rate the risk of loans for its customers. If this occurs, then the company may be finished.
I think the odds of this happening are low, as Upstart's AI model uses more information to gauge a customer than a FICO score, so defaults will likely not occur any more often than on FICO-based loans.
Additionally, in a move that upset investors, Upstart utilized its model to take on some loans on its balance sheet in the second quarter. While it doesn't plan on becoming a bank (it wants to stay a fintech), management believes it has a prime opportunity to make money using its platform's capabilities.
Upstart is bullish on its capabilities, but what's happening to the stock?
An unbelievable stock valuation
In October 2021, Upstart's stock nearly eclipsed $400 per share with a valuation of 48 times sales. That is an extremely high expectation to live up to, even if the company's revenue was growing at more than a 150% year-over-year pace for multiple quarters (Upstart's revenue rose 1,018% in the second quarter of 2021 alone).
Eventually, the hype blew off, which caused the stock to tumble. At $21 per share and a valuation of 1.9 times sales, it has undoubtedly shed its warp-speed growth valuation.
However, I believe this level is far too low for a company like Upstart. First, let's look at its nearest competitor, Fair Isaac Corporation. It trades at 8.3 times sales, despite reporting 3% revenue growth in its most recent quarter. For comparison, Upstart's revenue rose 18% year over year in the corresponding period.
As another check in Upstart's favor, it trades at 23 times earnings (compared to Fair Isaac's 30), even though the business was unprofitable in the most recent quarter. That's right, despite losing money in the quarter, it still trades at a cheaper valuation than Fair Isaac despite only having three profitable quarters.
Still, using Upstart's past achievements doesn't let investors know what it will do in the future. In Q3, revenue is expected to fall about 25% and post a net income loss of around $42 million. And analysts expect to see the company deliver only about 6% revenue growth next year.
So why am I such a believer in Upstart's stock if it looks as if the company is sliding downhill? First, I think the AI model is genuinely a difference-maker. As more banks and lenders recognize its usefulness, it should achieve wider adoption and dramatically increase Upstart's revenue. Second, even though the company's revenue growth isn't fantastic right now, I believe it can regain it its pace through the wider distribution of its model. To top it off, with the stock priced at a meager 1.9 times sales, its price-to-sales ratio is lower than that of a major bank such as Bank of America.
Upstart's stock has burned many investors with its drop; while it could take years to regain its previous price point (it may never regain those highs, too), I think the future is still bright for the business, and investors may regret not owning the stock on the way up.
