Why buying Upstart stock now could be a stroke of genius

Whenever consumers apply for a loan, they worry about one thing: their credit score. A few points up or down could make a big difference in the interest rate, which could add up to a lot of money over the life of a loan. Especially for those just starting out, a good credit rating can be hard to achieve, even with a clean record.

To better assess the risk, Reached (UPST -2.70%) created its artificial intelligence (AI)-based model, which it claims assesses creditworthiness better than Just Isaac Corporationit is (FICO 1.52%) FICO score. If you judge the product solely by the company’s stock price, you might think it’s a flop, down almost 95% from its all-time high. However, I think this is a wrong way to judge the company, and its stock may also be undervalued.

A better credit scoring model

Upstart claims it can assess risk better than a traditional FICO model, and it provides this chart to back up its claims:

Image source: Upstart.

You can see that borrowers with excellent FICO scores (700 or higher) with terrible Upstart Risk Level (E-) default on 10.2% of their loans per year. This means that an unsuspecting lender can offer these borrowers the best rate when they should be charging them a premium because of their risk. Overall, Upstart’s model does a much better job of 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 might incorrectly assess the risk of loans for its customers. If this happens, the business may be terminated.

I think the odds of that happening are low, because Upstart’s AI model uses more information to rate a customer than a FICO score, so defaults probably won’t happen more often than on FICO-based loans.

Additionally, in a move that upset investors, Upstart used its model to take out loans on its balance sheet in the second quarter. Although it does not plan to become a bank (it wants to remain a fintech), the management believes that it has a great opportunity to make money using the capabilities of its platform.

Upstart is optimistic about its abilities, but what happens to the title?

Incredible market valuation

In October 2021, Upstart’s stock nearly eclipsed $400 per share with a valuation of 48 times the sales. That’s an extremely high expectation to live up to, even though the company’s revenue grew at a rate of more than 150% year-over-year for several quarters (Upstart’s revenue grew 1,018 % in the second quarter of 2021 alone).

Eventually the hype exploded causing the stock to plummet. At $21 per share and a valuation of 1.9 times sales, it has undoubtedly lost its high-velocity growth valuation.

However, I think this level is far too low for a company like Upstart. Let’s first look at its closest competitor, Fair Isaac Corporation. It trades at 8.3 times sales, despite revenue growth of 3% in its latest quarter. By comparison, Upstart’s revenue grew 18% year-over-year during the corresponding period.

As another check in favor of Upstart, it trades at 23 times the earnings (compared to Fair Isaac’s 30), even though the business was not profitable in the last 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.

Yet using Upstart’s past accomplishments doesn’t tell investors what it will do in the future. In the third quarter, sales are expected to fall by approximately 25% and show a loss of net income approximately $42 million. And analysts expect the company to only see revenue growth of around 6% next year.

So why do I believe in Upstart stocks so much if it looks like the company is slipping? First, I think the AI ​​model is a real difference maker. As more banks and lenders recognize its usefulness, it is expected to gain wider adoption and significantly increase Upstart’s revenue. Second, while the company’s revenue growth isn’t fantastic right now, I think it can get back on track with a wider spread of its model. To top it all off, with the stock price at a measly 1.9 times sales, its price-to-sales ratio is lower than that of a major bank like Bank of America.

Upstart’s stock burned many investors with its fall; while it could take years to regain its previous price (it may never regain those highs too), I think the the future is still bright for the company, and investors may regret not own the stock on the rise.

Bank of America is an advertising partner of The Ascent, a Motley Fool company. Keithen Drury holds positions in Upstart Holdings, Inc. The Motley Fool holds positions and recommends Upstart Holdings, Inc. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.

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