How to Get Into Fintech

There are some clear growth trends in today's market, and financial technology, or fintech, has tremendous potential over the coming years. 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 it?

What is fintech?

The word fintech, a combination of finance and technology, refers to companies that apply new and innovative technologies to financial businesses. Fintech companies may be involved in payment processing, blockchain technology and cryptocurrencies, online and mobile banking, person-to-person payments and lending, financial security software, billing systems, or investment services.

Valuation

Fintech valuation methods

There are two components to properly analyzing fintech stocks. On the one hand, it's important to crunch the right numbers to ensure the business is performing well and on the right path. On the other hand, it's just as important to go beyond the numbers to get an idea of the opportunities and factors that are tough to express numerically.

Metrics

Fintech metrics to consider

Using traditional valuation metrics, such as the price-to-earnings (P/E) ratio or price-to-sales (P/S) ratio, can make analyzing fintech stocks difficult. Unlike many big banks and other traditional financial sector stocks, many of the most promising fintech companies aren't profitable yet or are barely in the black, and many trade for seemingly high multiples of their annual revenue.

To be perfectly clear, if a fintech 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 isn't worth investing in. You should 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. Strong revenue growth can easily justify a high price-to-sales valuation.

Price-to-earnings-growth (PEG) 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 over time. Fintech companies often report their revenue retention rates (they may have slightly different names for this). If this number is more than 100%, the company is doing a great job earning more business from its existing customer base.

Margin expansion

Investors in high-growth companies that aren't yet profitable must be able to identify and 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.

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 and sales growth to make sure it's trending in the right direction.

Beyond numbers

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 the best value relative to their growth rates. But valuation itself doesn't tell the whole story -- after all, many people thought Amazon (AMZN 1.52%) stock was ridiculously expensive when it was trading for a 10th of today's price.

With that in mind, it's very important to go beyond the numbers when analyzing fintech stocks as investment opportunities. 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 concept 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 guarantee a company's success, it can help to make the long-term case for a company with durable competitive advantages.

As an example, payment processing leader Visa (V -0.59%) has about $12 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 the shareholders? Do the managers have lots of successful experience in similar roles?

Related investing topics

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.

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