The do-it-yourself brokerage app Robinhood Markets, which will trade on the Nasdaq exchange with ticker HOOD, has played a pivotal role in the democratization of finance with its low-cost, easy-to-use business model. The firm packs quite a punch with its $80.9 billion of assets under custody -- with customers ready to pull the trigger on the next high-flying stock.
Alongside its achievements, the company is facing lawsuits for limiting buy orders for popular short squeeze stocks. But its value proposition far outweighs its woes -- here's why I think it's a good idea to invest in its IPO.
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The pros of investing in Robinhood
Robinhood's purpose isn't too different than what the namesake 13th-century English folk hero tried to do. The app charges no trading commissions nor any account fees for the average consumer. Instead, it is high-net-worth institutional investors and entities who foot the platform's bills. The company makes most of its money by selling customers' order flow to quantitative trading firms, which then take microseconds to position themselves behind a stock before the buy/sell order arrives. That's not necessarily a bad thing for long-term investors -- as fighting over who has the trading edge over a microsecond transaction isn't remotely relevant to how a stock will behave in two or five years.
During Q1 2021, Robinhood's revenue increased by a staggering 309% year over year to $522.2 million. Record-level speculation among retail investors with meme stocks was largely responsible for this growth. Since its app doesn't charge any commissions, it became a pivotal instrument in purchasing large amounts of out-of-the-money (OTM) options on heavily shorted stocks to orchestrate a gamma squeeze -- as was the case with GameStop (GME 2.56%). In fact, options trading volume on Robinhood is nearly 12 times that of its biggest competitor, TD Ameritrade.
Moreover, if we were to exclude financial expenses (such as a $1.49 billion change in fair value of its convertible notes), then Robinhood brought in a solid $59.25 million in pre-tax profits in the quarter. That is far better than the pre-tax loss of $52.6 million in Q1 2020.
Robinhood is seeking a $40 billion valuation -- implying a price-to-sales (P/S) multiple of 19 with its Q1 sales annualized. The premium here seems pretty fair for its ability to achieve both high-flying growth and profitability.
The secret sauce behind its profitability is that Robinhood doesn't need to spend a lot of money on marketing. It is the brokerage of choice for the 10 million strong (and growing) r/WallStreetBets community, who promote the app by proxy as they share their profit and loss (P&L) statements directly from their Robinhood accounts. In addition, over 80% of Robinhood customers sign up from word of mouth or referrals. The app has more than 31 million users.
Benefits outweigh the risks
Robinhood is not without its drawbacks. The company currently faces 49 class action lawsuits surrounding its oversight of trade surges in the beginning of 2021, alongside U.S. congressional and regulatory investigations.
It's also important to note that Robinhood is incentivized to encourage frequent and large trades: Long-term buy-and-hold investing on the app doesn't make the company much money at all. Instead, 2% of Robinhood users who are high-volume day and swing traders generate a disproportionate amount of revenue. The median age of users on the app is only 31, and many lack extensive financial experience -- leading to criticism that the app encourages new investors to engage in excessive risk-taking in order to turn a profit.
But Robinhood has always been popular among millennials and Gen Z -- and that momentum isn't going away anytime soon. Younger investors simply have the time in the market needed to take on a great deal of risk. In this way, Robinhood is their means to an end. What's more, making bad trades at a young age hurts -- but they aren't as difficult to come back from as they might be for investors nearing retirement, for example.
Overall, Robinhood has a significant value proposition. Its business model comes down to achieving a win-win for all, no matter the investor type. If you have spare cash on hand, consider giving the promising tech stock a chance.
