Language learning app Duolingo (DUOL -4.49%) went public a little over a month ago in an initial public offering. It's fair to say the IPO was a success. Initially shares were estimated to have an IPO price as low as $85, but eventually were priced at $102. Then when shares hit the market, they immediately popped to over $141 per share, clearly showing how hot this IPO stock is.
Duolingo's stock may be hot, but it's important for investors not to get caught up in the hype. Stocks aren't tickers on a screen; they're businesses. As such, it's important to understand Duolingo's business model -- only then can we know if it will make a good long-term investment. Regarding Duolingo's business model, let's address the most basic part: the four ways Duolingo makes money.
1. Monetizing non-paying users
For those unaware, Duolingo is an app that helps people learn another language, with almost 40 languages supported right now. The app is free to download and use. This significantly removes friction compared to other language learning programs that charge hundreds of dollars upfront. Even if you're just casually interested in learning Spanish, for example, you can simply download Duolingo's app.
Right now, there are roughly 36 million monthly active users learning on Duolingo's app who aren't paying a dime. To monetize this large user base, Duolingo does what a lot of businesses do: It shows them ads.
In 2019 and 2020, only about 17% of Duolingo's revenue was generated from displaying ads. Since going public, the company already reported financial results for the second quarter of 2021. In Q2, ad revenue increased 33% year over year -- good growth considering its overall user base declined. However, it declined to just 15% of the company's total revenue. And this is due to how many users are upgrading to a subscription product.
2. Enticing users to upgrade
For those tired of ads, Duolingo offers a subscription product called Duolingo Plus. As of Q2, there were 1.9 million subscribers. That was a 46% increase from the same quarter last year and the highest percentage of paying users (5.1%) in the young company's history.
Duolingo Plus' relatively small user base generated 73% of total revenue in 2020 and 74% in Q2. It's not uncommon for a small subset of a company's users to account for the bulk of revenue. For example, only 20% of Pinterest's users are in the U.S. but they account for 78% of revenue.
Pinterest can work on monetizing international users better but it could be a lengthy process. This is an advantage for Duolingo. If it can keep getting non-paying users to subscribe, its revenue can make big jumps in a small amount of time.
3. Fluency certification tests
Some people learn another language for fun. But for others it's more serious. They may be looking for employment or entry into a university. And for these kinds of things, they need to be certified to a particular level of fluency.
Language proficiency tests aren't new, but Duolingo's is particularly affordable at just $49. And considering this test is recognized at prestigious institutions like Yale, there's clear incentive to take Duolingo's English test over other options.
Duolingo's English test accounted for just 9% of revenue in 2020 but was its fastest-growing segment -- up almost 1,400% year over year. The growth rate slowed to just 5% in Q2 but still accounted for 8% of total revenue.
Going forward, I believe this segment has legs to run. According to Ethnologue, there are nearly 1 billion non-native English speakers globally, making it the world's most spoken language overall. Therefore, it stands to reason that there are plenty of people looking to be certified in English so they can pursue new opportunities.
4. Selling virtual goods
Finally, we can't overlook virtual goods, which accounted for 2.4% of Duolingo's Q2 revenue. By engaging with the app, users can earn points -- called gems -- that can be used to access certain content or speed progress through the program. Don't have gems? That's fine: You can buy some!
In Q2, this revenue segment grew roughly 326% year over year. I wouldn't expect this to ever be a meaningful income stream for Duolingo. That said, since these gems are virtual, revenue here drops pretty much straight to the bottom line.
To wrap up, there's more to determining whether Duolingo stock is a good investment. There's factors like profit margins, how money is spent, and the stock's valuation to consider. But given how we've seen it makes money, investors should consider whether Duolingo can keep growing its overall user base and converting a higher percentage to its subscription product. If it can, then it's on a good long-term trajectory.