Can you make money by offering something for free? Some investors think so.

Robinhood, an online discount broker that burst on the scene by offering commission-free stock trades, is reportedly raising $350 million of capital in an investment that will value the company at $5.6 billion. Whereas TD Ameritrade (NASDAQ:AMTD) and E*Trade (NASDAQ:ETFC) generate millions of dollars in commissions by charging $6.95 per trade, Robinhood believes it can offer stock and options trades for free, making money from its users in other ways. 

Here are the three primary ways in which Robinhood makes money, and a discussion on the advantages and disadvantage of this unique business model.

1. Robinhood lends out your cash

Modern discount brokerages are as much lenders as they are stockbrokers. Uninvested cash that Robinhood clients keep in their accounts can be lent out to facilitate margin trades, invested in super-safe bonds, or deposited in a banking institution, earning Robinhood a small return on every dollar.

On an account with a $1,000 cash balance, the interest may not be all that material, perhaps as little as $20 per year, but when you have millions of such accounts, the interest earned on cash balances becomes a real revenue driver. Robinhood doesn't pass on the interest to its customers, so all this interest income flows straight to its top line. 

As interest rates rise, investing and lending out clients' cash will become a bigger driver of the brokerage industry's revenue and profit. This is why the brokers have been such strong stock market performers in recent months, as the market expects several more rate hikes, which should boost their bottom lines. 

Robinhood logo

Image source: Robinhood.

2. You don't have to pay for trades, but you can pay for other perks

Robinhood is best described as a "freemium" app that offers a basic level of service for free with the option to pay more for added functionality. Robinhood makes money from a package it calls Robinhood Gold, which gives its users additional features, including:

  1. The ability to buy stocks on margin (borrowing money to buy more stock).
  2. Access to premarket and after-hours trading (30 minutes before the market opens, and two hours after the market closes). 
  3. Instant access to deposits for trading (free members have to wait two days for deposits over $1,000 to be ready to use).

Robinhood Gold is primarily a margin service, since the price varies with how much margin the customer wants. The lowest tier costs $6 per month, which grants users the ability to use up to $1,000 of margin to buy more stock than they could with their cash balances. Notably, whereas most brokers charge you interest on margin that you use, Robinhood charges you to have access to margin. 

If you request $1,000 of margin from Robinhood, you'll pay a flat $6 per month whether you borrow $1,000 to buy stocks or just use $100 of it. This is very different from how other brokers operate. 

3. Robinhood sells your orders to market makers

When you place a trade to buy a stock through an online discount broker, the order is often sent to a market maker who pays the broker a small fee for sending trades to process.

These payments add up, and quickly. I estimate that TD Ameritrade and E*Trade earned $2.51 and $2.52 in such revenue per trade, respectively, based on disclosures in their most recent annual reports. Therefore, even if Robinhood doesn't collect a commission on each trade, it wants its clients to trade frequently. Order flow revenue typically varies based on the number of shares or options contracts traded. 

Brokers can also match up buyers and sellers on their own in a process known as "internalization." If one client wants to buy 100 shares of Advanced Micro Devices and another wants to sell 100 shares, the two orders could be matched up internally, and Robinhood could collect the very small difference between what the buyer pays and the seller receives. For a highly liquid stock like AMD, the spread between bid and ask prices is typically thin -- about $0.01 per share -- but when millions or billions of shares trade hands, these pennies add up. 

Is Robinhood profitable?

Since it's a private company, we don't have access to Robinhood's financials in the way we do with other publicly traded discount brokers. One could only speculate about how much it's really earning, or whether the no-commission business model is truly sustainable over the long term.

To be sure, many companies have tried, and largely failed, to give away free trades with the hope of making money in other ways. In 1999, Ameritrade launched, a commission-free brokerage service that was later folded into another service that charged commissions. In 2006, Zecco launched and quickly gained traction with the promise of free trades, but it was later sold to TradeKing, a broker that charged commissions on every trade. 

It's difficult to say whether or not this time is truly different. There are pros and cons to the commission-free model. Obviously, the only (but very big!) disadvantage from a business perspective is that Robinhood doesn't earn commissions on every trade as most discount brokers do. 

That said, there are some advantages of being free. I suspect Robinhood's average account places more trades than other discount brokers, since Robinhood doesn't currently offer Individual Retirement Accounts (IRAs) or mutual funds, which tend to attract investors who place fewer trades, so it generates more order flow revenue per account. Its no-frills service enables it to avoid expensive brick-and-mortar branches. E*Trade, Charles Schwab, and TD Ameritrade have thousands of branches between them to service their customers needs.

Finally, but perhaps most importantly, giving up commission revenue likely enables Robinhood to attract customers at a much lower cost. Ultimately, the brokerage business is a marketing business, as brokers spend heavily to find new customers each and every year.

E*Trade recently acquired more than 1 million brokerage accounts from Capital One at a price of $170 million, or approximately $170 per account. In prepared remarks on a conference call, an E*Trade executive said that the purchase price was "well below our typical customer acquisition costs for a broad set of customers that meet our target profile." I take that to mean that E*Trade typically spends much more than $170 to find one new customer.

How much Robinhood spends to acquire a new account isn't known for certain, but from data on its website I can estimate that it acquires the marginal account through its referral program for no more than $25 each. That's a mere fraction of the roughly $170 per account that E*Trade paid to acquire clients from Capital One, though we can quibble about whether Robinhood's customers are on par with Capital One's. 

It's hard to say whether Robinhood is profitable, or whether commission-free trades are sustainable for the long haul, but one thing is certain: So long as Robinhood can maintain its no-commission business model, it will be a thorn in the side of brokers who have to convince prospective customers that they should pay for a basic service that a competitor offers for free. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.