Robinhood Markets (HOOD 2.54%) recently completed its initial public offering (IPO), and the company's valuation shows that investors have high growth expectations. Its market capitalization currently stands at $42 billion, which looks massive in comparison to Robinhood's tiny profit of $7.4 million in 2020. 

The company's growth so far is admittedly impressive. For example, Robinhood's cumulative funded accounts have more than tripled to 18 million since the end of 2019. Similarly, assets under custody have increased from $19 billion at the end of March 2020 to nearly $81 billion through the end of March 2021. But before you decide to buy shares, you should be aware of obstacles in Robinhood's future.

An investor placing a trade on a mobile phone.

Image source: Getty Images.

How Robinhood makes money

Many investors are probably wondering how the heck Robinhood is worth $42 billion when it offers free trades. How does the business make any money?

It's pretty simple, but it's also somewhat controversial. A significant majority of Robinhood's revenue is transaction-based. Robinhood basically serves as a middleman between users placing orders to buy or sell shares and the market makers (big financial firms) that facilitate the execution of the trades. Those market makers earn revenue on the spread between what the stock is valued at and what it is traded at.

Instead of charging commissions for stock orders, the market makers pay Robinhood fees for directing customer order flow to their in-house execution business. Payment for order flow (PFOF) allows Robinhood to offer a trading platform at no cost to customers -- but the PFOF business model creates potential conflicts of interest between Robinhood and its users because some feel that Robinhood could be more focused on the interests of the market makers (and generating fees) than in getting the best stock trading deal for its users.

Regulatory risks

Robinhood was previously investigated over its PFOF practice and whether it had sacrificed customer service quality in exchange for PFOF fees. In December 2020, Robinhood agreed to pay $65 million to settle charges with the U.S. Securities and Exchange Commission over misleading clients about the quality of its service and how it generates revenue. However, Robinhood says that this previous misstep doesn't reflect the current company.

Still, this practice of getting paid by financial firms is a risk to user growth since it could harm trust in the Robinhood brand. It also puts Robinhood in the crosshairs of regulatory authorities, where there has been an ongoing debate about whether the practice of using PFOF should be banned altogether. PFOFs have already been effectively banned in the U.K. due to conflict-of-interest concerns. 

In the first quarter, PFOF and transaction rebates for cryptocurrency trades totaled 81% of Robinhood's total revenue of $959 million, which increased 245% year over year. 

What is the upside?

The potential regulatory obstacles are something to be aware of, but Robinhood still has several qualities that could make it a very profitable investment.

Robinhood benefits enormously from being one of the earliest services to offer free stock trades and fractional shares. Over half of people between 18 and 44 years old in the U.S. recognize the Robinhood brand, which is turning into a major competitive advantage.

Its brand recognition might actually help the business navigate around the threat of regulation since a ban of PFOF use in the U.S. would, in effect, make it more costly for millions of small investors to access the financial markets. The politicians considering rule changes may not want to risk a consumer backlash over that decision.

In essence, Robinhood is gaining more negotiating power with market makers the more people join the platform. The company believes that 50% of all newly funded retail accounts in the U.S. from 2016 through 2021 were created on Robinhood. That means Robinhood is gaining share quite rapidly in the brokerage market.

Several archery arrows hitting the bullseye in a single target.

Image source: Getty Images.

Robinhood seems to understand the needs of the little guy better than the big banks and large brokerage services, which is working to its advantage. It's converting waves of new investors to its platform by delivering a welcoming and jargon-free sign-up process without all the paperwork that traditional brokers require. 

It's not yet producing much of a profit, but that's because management is reinvesting revenue back into the business to drive more growth. Similar to Square's strategy with its Cash app, Robinhood is positioning itself as a bank in your pocket. It has rolled out cash management features and Robinhood-branded debit cards and earns a subscription fee from Robinhood Gold, which provides members access to premium research and other trading tools. 

Will buying Robinhood stock help your millionaire goals?

It's difficult to say whether a small investment will grow enough by 2030 to make you a million bucks. Moreover, some investors may want to pass on Robinhood in favor of other growth stocks that don't face the regulatory risks and legal battles that Robinhood is continuing to deal with.

Still, Robinhood is growing very rapidly and gaining incredible brand recognition in the process. If it can avoid regulatory hurdles, its stock offers significant long-term upside.

Editor's note: An earlier version of this story incorrectly stated how much Robinhood has in assets under custody.