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1 Green Flag and 1 Red Flag for Upstart

It's hard to believe that just last October, Upstart Holdings' (NASDAQ: UPST) stock was sporting a valuation of more than 500 times trailing-12-month earnings. At recent prices, it had toppled to a price-to-earnings ratio of less than 20, which is almost laughable for a growth stock.

Is it undervalued now? Or are there enough challenges that this reflects the true value of the stock? Let's examine it from both angles.

Green flag: Many new clients

Upstart's business has been growing by leaps and bounds, with explosive revenue growth since it went public -- revenue more than tripled in 2021. Investors went crazy over this stock, but the enthusiasm faded after it posted a negatively received outlook for the 2021 fourth quarter followed by a general tech sell-off in the broader market.

Nevertheless, revenue growth is still strong, with a 154% year-over-year increase in the first quarter. Even better -- and the reason to be confident about the potential here -- is how many partners continue to join the company's lending platform.

Upstart uses artificial intelligence and machine learning to run thousands of data points and evaluate a potential borrower's credit risk. It claims to do this better than traditional FICO scores, which take a very broad view of a borrower's credit and deny loans to thousands of would-be borrowers whose actual risk of defaulting may be low. When partner banks or credit unions use Upstart's platform, they approve more loans without adding risk, putting more of their money to work -- a win-win for lenders and borrowers.

Although in the current atmosphere there may be less lending going on, which we'll discuss in a moment, Upstart continues to add banking partners, making it more competitive despite potentially slowing loan originations. Its services also become more important in a more stagnant environment, as higher approval rates could stem some of the slowdown.

As of the end of the first quarter, there were 57 banking and credit union partners, representing a more than 200% increase from just 18 last year. Upstart's added three new partners since then. Its auto loan platform also expanded, from 162 dealer rooftops in the first quarter last year to 525 this year. More banking partners and dealer rooftops can help the company grow its business despite the tight environment, and its services also become more attractive.

Red flag: Rising interest rates

The tough pandemic economy induced lowered interest rates to stimulate the economy. That was great for borrowers, and it had some positive effects for banks in the form of increased loans and lower default rates. Now they're being raised to fight inflation, which is good for banks because they can charge higher interest rates on loans, feeding profitability, but also translates into fewer loan originations. This in turn affects a company like Upstart, whose platform is used to fund the loans that might be less abundant in this market.

Investors were already alarmed at the company's disclosure that it was increasing the loans it was holding on its own books in the first quarter, and that led to part of the stock sell-off (the company has since tried to reassure investors that it won't make a habit of this). But more acutely, Upstart's growth avenues will be somewhat blocked if there are fewer loans going out. Higher interest rates will also affect Upstart's algorithms, which determine who's a credit risk. Elevated rates increase the risk of default, and fewer loans could be approved through the platform.

Bank stocks are cyclical, and they typically move up and down as a category depending on the macro environment. Because Upstart works with banks, its growth rates may slow down in the short term, and it may lower its outlook for the second half of the year. That would make its stock look more fairly valued right now.

Should you buy Upstart stock?

There are other reasons to be excited about Upstart besides its new partners, such as increasing profits and a huge market opportunity in auto lending, as well as other products down the line. While the short term could be a challenge so long as interest rates remain elevated, this may present as opportunity to buy shares at a better valuation. Risk-averse investors may want to start out with a small position.

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Jennifer Saibil has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Upstart Holdings, Inc. The Motley Fool has a disclosure policy.


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