Top Stocks to Watch in Solar Energy

Solar energy is a booming business, particularly in the southwestern U.S. Image source: SunPower.

Solar energy is a booming market worldwide that has the potential to upend the energy industry as we know it. A solar power plant can now be built that creates energy for less than the cost of nuclear, coal, and some natural gas plants, and expenses are falling every year.

If you want to know where to start investing in solar energy, here are three stocks that will tell you where the industry is headed.

Source: First Solar.

Utility stock to watch The solar industry is generally split into three different end markets: residential, commercial (think Wal-Mart's rooftop systems), and utility-scale. These three markets have very different interactions with customers and solar itself.

The first stock on my list is First Solar , which is almost exclusively a utility-scale solar project builder. That means the company builds massive solar projects and negotiates a contract with the appropriate utility for the energy from that project over 10, 20, or 30 years. This assures long-term cash flow and a solid return on investment.

First Solar makes a thin-film solar technology that has long been cheaper but less efficient than typical crystalline silicon cells. But First Solar's research and development lab has been working overtime to increase efficiency, and in the first quarter its best line ran at 15.6% efficiency, toward the high end of what a conventional solar panel would provide. If that momentum continues -- and management has pledged to deliver a 19.5% efficient panel by 2017 -- the company will be in good shape.

When watching solar, look to First Solar for demonstration of the health of the utility-scale solar business. If there is growing demand and a strong backlog, which currently stands at 3.9 gigawatts at First Solar, the-large scale solar business should be in good shape.

Residential solar stock to watchSolarCity specializes in installing residential solar systems around the U.S. It is on target to install 1 million systems on rooftops by mid-2018. The chart below illustrates the company's incredible growth over the past three years.

Source: SolarCity Q1 2015 earnings presentation.

Here you'll want to watch the company's growth over the next five years, particularly in 2017. That's when the 30% U.S. investment tax credit, or ITC, for solar projects expires, and installations are expected to decline afterward. SolarCity is highly dependent on the ITC to help finance solar leases, so the program's expiration could throw its entire business model out of whack. I'll be watching SolarCity's response closely.

Jack-of-all-trades The first two companies in this article specifically focus on either large or small solar projects with minimal overlap. SunPower is unique because it makes the industry's most efficient solar panel (21.5%) and plays a part in everything from very small projects to the largest solar power plants in the world.

SunPower's C7 concentrator product. Source: SunPower.

SunPower can leverage its technology to install more energy production in tight spaces (like a home's roof) or concentrate the sun's energy using mirrors to create a low-cost utility-scale product (as you see on the left).

What's worth watching with SunPower is how the industry values efficiency and technology. Long term, I think higher efficiency will lead to better returns on projects and higher margins for SunPower. But sometimes the solar industry can surprise us like it did by rapidly lowering solar manufacturing costs in China, forcing many U.S. companies into bankruptcy. And there's always new technology that could emerge to make SunPower's technology lead a moot point almost overnight.

An energy revolution worth watching First Solar, SolarCity, and SunPower are worth watching because they are industry leaders with very different strategies in the solar sector. First Solar will benefit if utility-scale projects boom, while SolarCity would be the winner if residential solar grows, and SunPower would hit pay dirt if installers focus on efficiency.

At different times each company has taken its turn as the apparent next great solar stock. But the development of the industry will tell us which will be the biggest winner over the long term.

The article Top Stocks to Watch in Solar Energy originally appeared on Fool.com.

Travis Hoium owns shares of SunPower. The Motley Fool recommends and 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.