Robinhood Markets (HOOD -1.38%) has introduced stock trading to a new generation. As of March 2021, over 18 million users had set up funded accounts on its platform, up from 7.2 million in March 2020. The platform's increasing popularity helped to drive revenue growth and eventually led to Robinhood's recent initial public offering (IPO) at $38 per share. However, after reaching an intraday high of $85 per share in the first few days of trading, it has fallen back to the mid-$50s per share range. The question now is whether this sell-off is a warning to get out, or an opportunity for Robinhood to make risk-tolerant investors millionaires?
How Robinhood makes money
Indeed, Robinhood has brought stock investing to a new type of individual investor. Traditional online brokerages such as Charles Schwab used to charge a commission for trades. However, Robinhood grew in popularity by offering commission-free trades, inducing brokerages like Schwab to follow suit. It also has advanced the practice of fractional-share sales. This helps to make a stock such as Amazon (AMZN 0.24%), which currently sells for just under $3,400 per share, accessible to small investors, by allowing them to buy just a part of a share at a more affordable price.
Despite its "free" business model, Robinhood can earn money in a variety of ways. Among these sources are fees from its Robinhood debit card, earning interest on uninvested cash, and loaning stock to counterparties. Another revenue-generating service is Robinhood Gold, which provides margin investment services and increased access to research for a user fee.
Nonetheless, the revenue source that has caused the most controversy is its use of payment for order flow, in which Robinhood sells customer market orders to market makers who execute the trades. Market makers set the bid and ask prices, which are the prices where an investor sells and buys a stock, respectively. At a given moment, they may sell shares of Microsoft at $288.60 per share at the same time they buy them at $288.50 per share. Market makers earn money on these price differentials and will then send volume-based rebates to Robinhood.
This practice brought unwanted scrutiny when the Securities and Exchange Commission (SEC) found Robinhood was not fulfilling its duty to execute trades at the best price, depriving customers of an estimated $34.1 million. Robinhood paid a $65 million fine and agreed to employ an independent consultant to review order flow policies and procedures. Admittedly, SEC violations do not necessarily sink stocks. Still, such restrictions could compel investors to discount Robinhood.
Despite the concerns, Robinhood remains in growth mode. It logged revenue of $959 million in 2020, a gain of 246% versus 2019 levels. Limiting the growth of operating expenses to 146% during that period helped it earn a net income of $7.5 million that year, a dramatic turnaround from its $107 million net loss in 2019.
The problem for prospective buyers is that it has already experienced so much of this growth that it is likely too late for new investors to become millionaires from a $10,000 initial investment in Robinhood.
As of the time of this writing, Robinhood has around a $47 billion market cap. To reach the $1 trillion market cap only attained at this point by tech's largest companies, it would have to double slightly more than four times. Doubling a $10,000 investment four times only gets an investor to $160,000.
This compares poorly to Amazon's post-IPO situation. Amazon's July 1997 market cap of under $500 million left tremendous potential for gains. Today, Amazon's market cap stands at around $1.7 trillion, an increase that could have turned an initial $10,000 investment into approximately $34 million.
The bottom line
In the end, Robinhood stock will probably not mint too many new millionaires. No doubt, Robinhood has brought in massive top-line growth by expanding the pool of potential stock investors. Despite troubles with the SEC, Robinhood remains positioned to drive investor profits. However, given its large-cap status, this fintech stock will likely not turn small investors into millionaires without help from other names.