What You Need to Know Before Investing in Solar Stocks

By Markets Fool.com

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Entire communities are going solar, changing the energy landscape. Source: SolarCity.

There may not be an industry with greater potential for growth today than the solar industry. It's a $120 billion industry today that's upending an electricity industry that will be worth $4 trillion annuallyby 2035 -- and it could go on to upend transportation fuel as well. That's incredible growth potential for a solar industry that has already grown 30% compounded annually over the last 20 years.

But before thinking any old solar stock will be a good investment, there are a few things you should know when picking solar stocks.

Not every solar company is created equal
Today, there are a lot of publicly traded solar companies, but they're not all the same. Solar panel makers like Trina Solar , Canadian Solar , First Solar , and SunPower have many differences even within the manufacturing group, but at their core, they make the panels that turn the sun's energy into electricity.

Installers like SolarCity and Vivint Solar buy the panels made by the companies I mentioned above and tie together financing and installation to bring solar energy to residential homeowners and commercial buildings. SunEdison is another project builder that's more focused on commercial and utility-scale projects.

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There's also another group of newly formed yieldcos like NRG Yield , TerraForm Power , and the upcoming 8point3 Energy from First Solar and SunPower.

To complicate matters, there is crossover between manufacturers, installers, financiers, and project owners. Depending on your risk tolerance, some of these investments may not be right for you, and it's also important to understand how companies are different from one another, and how different parts of the industry interact with each other.

SunPower's solar panels are more efficient than competitors, meaning more energy generation can be packed on a rooftop. Source: SunPower.

Technology matters
One of the biggest ways solar companies can differentiate themselves is through better technology than competitors. For example, SunPower makes solar panels that are up to 21.5% efficient in converting the sun's light into electricity, while conventional panels from Trina Solar or Canadian Solar are 14%-16% efficient. First Solar, on the other hand, makes a thin-film product that has long been lower cost and lower efficiency (14.4%) than conventional panels, and the company has built utility-scale racking systems that make installing systems very low cost.

The next phase of technology differentiation comes from the interaction between the solar system, the homeowner, and the utility. This will bring energy management and storage into the equation, maximizing the revenue potential from a solar system by integrating a growing amount of information behind the scenes.

Whether the company you're looking at is a panel maker moving into installations, or an installer buying panels, knowing how their technology stacks up to competition and how they're integrating a wider world of energy services is key to ensuring their survival long term.

Know your market
Technology can differentiate solar companies, no matter the market they serve. But knowing what market companies are going after can play an important role in how an investment plays out.

For example, SolarCity and First Solar are two of the largest solar companies in the world, and both are large players in the U.S. market. But they play to very different markets within the U.S. solar industry. SolarCity is a leading residential solar installer, and First Solar is a utility-scale project builder. There are reasons to like both markets, but these two companies very rarely overlap, even though they're both giants in solar.

Competition within these markets is very different, and so is financing. But it may be subsidies and policy that play the biggest -- and most underestimated -- role.

Utility-scale solar is the world's biggest solar segment. Source: First Solar.

Subsidies and policy matters
Today's solar industry is highly dependent on both subsidies, in certain locations, and policy that gives access to the grid. Understanding how subsidy and policy changes impact business can keep you from making big mistakes in solar.

There have long been boom and bust cycles for the solar industry in different countries around the world as things change. For example, Germany was once the world's biggest solar market, driven by a very high feed-in tariff rate for solar installations and preferential access to the grid. But as the tariff declined, the industry suffered, and it's now smaller than it was a few years ago.

One country to watch in the next two years is the U.S. The investment tax credit (ITC), which provides a 30% tax credit for the value of a solar system, essentially pays for half of the installation cost for companies like SolarCity, Vivint Solar, First Solar, SunPower, and SunEdison, but it's most concerning for residential solar installers.

SolarCity and Vivint Solar are currently driven by high-margin leases that won't likely be economically attractive when the ITC expires in 2017, meaning customers will move to loans. That will make the buying process more transparent, meaning more competition on costs and lower margins than they experience today. It could even cause a contraction in the U.S. solar market that could last multiple years.

Geographic diversity can spread out some of that subsidy and policy risk over many markets.

Location matters
Companies that have exposure to multiple countries are at an advantage in the boom and bust cycles of solar, and at the very least, investors should be cautious of companies reliant on one market. If your company can be upended by a simply policy shift, it's a reason not to buy the stock in the first place.

Three of the most geographically diverse companies today are SunPower, SunEdison, and First Solar, who have installations around the world and have been able to adapt to different policy environments over the past decade. With all else equal, I would rather own a solar company that operates in a diverse number of countries rather than one reliant on a single country that could go bust at a moment's notice.

Know your risks
The solar industry is full of potential, and as an investor, I'm highly invested in its future. But it's also full of risks, and there are remnants of companies like Solyndra, Evergreen Solar, Suntech Power, and many others to show just how risky it can be.

Get to know both the potential and the risks of the stock you're looking at before buying into the solar industry. It's better to be safe than sorry when the upside potential is this big for investors.

The article What You Need to Know Before Investing in Solar Stocks originally appeared on Fool.com.

Travis Hoium owns shares of NRG YIELD INC and SunPower. The Motley Fool recommends SolarCity. The Motley Fool owns shares of SolarCity. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.