There are some clear growth trends in today's market, and few are more compelling as long-term investments than financial technology, or fintech. However, it can be difficult for investors to properly analyze fintech stocks since many of these companies are in the early stages of growth, and the analytical methods that work for traditional financial sector companies don't always translate well.
With that in mind, here's a quick guide to what you should look for when analyzing fintech stocks, both in terms of crunching the numbers and considering important nonnumerical factors.
What is fintech?
The word fintech, a combination of finance and technology, refers to companies engaged in the application of new and innovative technologies to financial businesses. To name a few examples, fintech companies may be involved in payment processing, blockchain and cryptocurrencies, online and mobile banking, person-to-person payments and lending, financial security software, billing systems, or investment services.
Fintech valuation methods
There are two components to properly analyzing fintech stocks. On one hand, it's important to crunch the right numbers to make sure the business is performing well and is on the right path. On the other hand, it's just as important to go beyond the numbers and get an idea of the opportunities and factors that are tough to express numerically.
Fintech metrics to consider
Using traditional valuation metrics, such as the price-to-earnings ratio (P/E ratio) or price-to-sales ratio (P/S ratio), can make analyzing fintech stocks difficult. Unlike many big banks and other traditional financial sector stocks, many of the most promising fintechs aren't profitable yet, or are barely in the black, and many trade for astronomical multiples of their annual revenue.
To be perfectly clear, if a company isn't profitable yet or trades for a nosebleed-level valuation based on P/E or P/S, it doesn't necessarily mean the stock is expensive. Also consider the following factors:
Sales growth: One of the biggest questions you should ask when trying to analyze a fintech stock, especially an unprofitable one, is how quickly the company is increasing its revenue. A high P/S valuation can easily be justified by revenue growth in the range of 50% or higher.
PEG (price-to-earnings-growth) ratio: This can be a useful growth investing metric if the companies you're looking at are profitable. Simply take the traditional price-to-earnings ratio and divide it by the company's projected earnings growth rate (ideally over the next few years). For example, a company with a P/E multiple of 100 and an earnings growth rate of 40% would have a PEG ratio of 2.5. This can help level the playing field between profitable companies growing at different rates.
Retention rate: Good fintech companies keep their customers. Great fintech companies get their customers to spend more money as time goes on. Fintechs often report their revenue retention rates (they may have slightly different names for this), and if this number is more than 100%, it means the company is doing a great job of earning more business from its existing customer base.
Margin expansion: Investors in high-growth companies need to understand the "path to profitability." That is, it doesn't matter too much if a company is profitable now as long as it looks like it will be highly profitable in the future. And, there are two sides to a company's path to profitability -- sales growth and margin expansion. It doesn't matter if a company grows its sales tenfold if it does so at the expense of its profit margin. On the other hand, the combination of strong revenue growth and expanding margins is the most surefire path to eventual profitability that you can get. So, when analyzing fintech stocks, it's a great idea to look at the company's operating margins for the past few years to make sure it's trending in the right direction.
Go beyond the numbers
One important lesson many investors (myself included) learn the hard way is that it isn't all about the numbers.
Nevertheless, valuation is still important. For example, looking at the PEG ratios of a few different fintech stocks can help you decide which is the best value relative to their growth rates. But valuation itself doesn't tell the whole story -- after all, many people thought Amazon (NASDAQ:AMZN) stock was ridiculously expensive when it was trading for a tenth of today's price.
With that in mind, when you're analyzing fintech stocks as investment opportunities, it's very important to go beyond the numbers. With high-growth investing, the qualitative thesis for investing can be far more powerful than the quantitative one. Here are a few nonnumerical factors to consider:
Durable competitive advantage: This is a concept that applies to value and growth stocks alike but is especially important to identify in companies that derive their value from future growth potential. Think of a durable competitive advantage as the X factor that will allow a company to protect its market share and expand its business over the next decade and beyond. This can take several forms, such as proprietary technology, scale advantages, manufacturing and distribution cost advantages, and network effects.
Market opportunity: You may have heard the phrase, "A rising tide lifts all boats." This logic applies to the fintech space. While a great market opportunity doesn't mean a company will be successful, it can help to make the long-term case for a company with durable competitive advantages. As an example, payment processing leader Visa (NYSE:V) has about $9 trillion in annualized payment volume flowing through its network. But the company estimates a $185 trillion worldwide payment opportunity -- that's a big market to fuel future growth.
Management: Never underestimate the value of strong and engaged management. Is a fintech company led by a passionate founder? Are the management team's interests aligned with shareholders'? Do the managers have lots of successful experience in other similar roles?
The bottom line on buying fintech stocks
When it comes to buying stocks in a rapidly growing industry such as fintech, finding the best investment opportunities isn't as much about crunching the numbers as it is about finding great businesses to invest in.