Of all the artificial intelligence (AI) stocks, few are as trendy as Upstart (UPST 2.76%). Even though Upstart has only been on the market since 2020, it has been involved with two impressive run-ups, followed by a subsequent stock price decline. However, both of these declines are due to investors not understanding Upstart's business.
So, if you want to be an Upstart investor, here are three things you must understand.
1. Upstart's product has remained effective
Upstart's alternative credit approval software is a significant upgrade over a traditional FICO score. Instead of looking at a handful of factors, Upstart considers education level, employment history, financial status, and many other items to better understand an applicant's financial well-being.
Partner banks can then give better rates to more applicants because they know the risk of a borrower not paying back the loan is better correlated when a borrower is assessed using the Upstart model versus a FICO one. This correlation can be seen in the table below.
Image source: Upstart.
As you can see, Upstart can identify borrowers with high credit scores but with a higher-than-average chance of defaulting on the loan. It can also find applicants with low credit scores who are dependable borrowers and pose little risk to lenders.
It's fairly proven that Upstart's model works, although we've yet to see it perform during a prolonged recession. Still, a large body of work supports Upstart's product quality. However, external factors are influencing Upstart's current state.
2. Interest rates steer Upstart
While Upstart has a great product, it is tied to macroeconomic trends. Because the Federal Reserve has raised interest rates over the past two years, loan demand has dropped because borrowing has become expensive. This is the intended effect of the rate hikes, but it takes a toll on companies like Upstart.
In the second quarter, Upstart originated nearly 110,000 loans, down significantly from last year's 321,000 total. Upstart is in the worst of the downturn, as many people borrowed what they wanted on favorable terms over the past couple of years. However, these loans will eventually be complete, and people must purchase a different vehicle or finance a project.
Although borrowers are less likely to take out a high-interest-rate loan, there will likely be an immediate demand surge if rates are cut. When the Federal Reserve will decide to reduce rates is a million-dollar question, but it's a safe bet that it will happen sometime in 2024.
But should investors purchase the stock in the meantime?
3. Upstart's valuation isn't representative of what it can be
Upstart's valuation can rise and fall quickly, as many investors get excited about what its technology can do.
UPST PS Ratio data by YCharts
But few realize that Upstart's business doesn't control its destiny; interest rates do. So, while the stock may not look cheap at 5 times sales, that's not the full picture.
We've already established that Upstart's loan originations have fallen off a cliff due to interest rates, but we haven't discussed what that did to revenue. Last year, Upstart's revenue was $228 million, while it was only $136 million this year, a 40% decrease.
So, while the stock may seem a bit pricey, if loan demand returns to previous levels, Upstart's revenue will drastically increase and make the stock look much cheaper.
So, what's a fair valuation for the stock? That's a question I don't have an answer for. We haven't seen Upstart operate in a standard interest rate environment over an extended period, so investors have no idea what a steady state looks like. As a result, investors are firing from the hip when determining a fair price for the company, which is why the stock often trades in large spikes.
Because Upstart's product doesn't have much cost associated with it, it makes sense that the valuation would be similar to competitor Fair Isaac Company, the originator of the FICO score. That stock currently trades for 15 times sales, so Upstart trades at a significant discount.
With Upstart's product at a low point in demand, today's 5 times sales price doesn't seem so bad. So, if you're interested in investing in Upstart, today isn't a bad time to purchase the stock. However, you'll have to be patient as the company is steered by the Federal Reserve's interest rate decisions.
