Is TD Ameritrade a Buy?

In a surprising shake-up of the brokerage industry, Interactive Brokers and Charles Schwab both announced recently that they would be dropping commissions on stock trades. Then other leading brokerages followed suit, including TD Ameritrade (AMTD +0.00%), which slashed its trading commissions from $6.95 to $0.

At first glance, a $0 commission business model might not seem like a great way to make money. Don't be so quick to judge. There are a couple of good reasons why this could actually be a net positive over the long run for TD Ameritrade and its investors.

Image source: Getty Images.

Other sources of revenue

You might think that commissions are the primary source of revenue for a company like TD Ameritrade, but you'd be wrong. It's certainly a big piece of the pie, but the majority of TD Ameritrade's revenue comes from other sources. Consider this breakdown of the company's past nine months of earnings:

Data source: TD Ameritrade fiscal 3Q 2019 earnings report. Covers the nine-month period from Oct. 1, 2018 through June 30, 2019.

TD Ameritrade's transaction-based revenue can be broken down even further: Trading commissions account for $1.135 billion, and the other $365 million comes from order routing revenue, which won't be affected by the $0 commission change.

Here's the takeaway: Just over 25% of TD Ameritrade's revenue had been derived from trading commissions. What's more, the commission revenue isn't exactly going to drop to zero. The company still charges $0.65 per contract for options trades, $25 for broker-assisted trades, and $5 for trades placed through its interactive phone system. So there will still be some commission revenue. In other words, this will affect less than one-fourth of TD Ameritrade's revenue.

A big competitive advantage

Before we go any further, I should say in the interest of full disclosure that I am a TD Ameritrade customer and have been using the platform since 2002 -- before there was even a "TD" in the name. I'm a huge fan of the company's product.

Having said that, I've also used E*Trade and Bank of America's Merrill Edge platforms for short periods in the past, and have also explored Robinhood, Schwab, and a couple of other online stockbrokers just to get an idea of how their platforms worked.

In my opinion, TD Ameritrade has the superior platform. It has the most user-friendly trading platform, especially for advanced investors, and offers educational tools for beginners that are second to none. There is also great access to research and other tools.

Before a week ago, all of this came at a premium. You had to pay a $6.95 commission to execute a trade, as compared with $4.95 for Schwab and $0 for Robinhood, just to name a couple others at different price points. This structure certainly made sense -- Robinhood has a largely no-frills platform, while Schwab's features rank somewhere in the middle.

However, now that stock investors can get TD Ameritrade's superior platform with the exact same commission structure, it could be a big competitive advantage going forward. I wouldn't be surprised to see a significant volume of asset inflows from investors who were previously using one of the cheaper brokers.

Worth a look at the new cheaper valuation

TD Ameritrade's shares are down about 28% since the commission wars occurred less than a week ago. As I mentioned, commissions are only about one-fourth of the company's revenue, so the loss of this income stream is already reflected in the stock price and then some. Plus, now that investors can get access to TD Ameritrade's superior trading platform, research, and other features without having to pay a premium, I wouldn't be surprised to see the company's client assets grow at a faster pace than the rest of the industry.

For these reasons, while I haven't pulled the trigger just yet, TD Ameritrade has quickly jumped to the top of my watch list and may become part of my portfolio if the current share price persists.