Shares of Robinhood (HOOD 1.46%) have fallen roughly 20% from their all-time highs. That puts the stock into its own bear market. Is this a buying opportunity or should investors avoid this discount broker? What happens during the next bear market should be a crucial factor in your decision-making process.
What does Robinhood do?
Robinhood is a discount stockbroker. It competes with companies like Charles Schwab and Interactive Brokers. Robinhood has been an industry disruptor, which has helped it expand rapidly. Most notably, it was the driving force behind commission-free trading that many of its peers ultimately adopted in some form.
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Robinhood's innovation didn't stop there. It was digitally driven from the start, utilizing an app to incorporate game-like elements into stock trading. It was quick to adopt crypto trading and, more recently, has incorporated sports betting into its system. You can argue whether sports betting can be classified as investing, but the company's generally younger client base wants to do it, so Robinhood obliged.
The stock has been a very strong performer as the company has grown. Although it has fallen 20% from its all-time high, it has still risen by about 1,100% during the past three years. Before you jump on board, there are a couple of negatives to consider.
Valuation and bear markets
The first thing that should worry investors is Robinhood's valuation. It has a price-to-earnings (P/E) ratio approaching 50. That compares to 24 for longtime industry leader Charles Schwab and 34 for well-respected Interactive Brokers. Robinhood is clearly more expensive from a valuation perspective than its peers.
However, it is also notable to compare Robinhood's valuation to that of the broader market. For example, the S&P 500 index's (^GSPC 0.06%) P/E ratio is roughly 31 at the moment. The average financials stock, using the Vanguard Financials Index ETF (VFH +0.08%) as an industry proxy, has a P/E ratio of about 19. Brokers only make up about 10% of the exchange-traded fund's portfolio, but it still highlights the high price tag being placed on a financial stock like Robinhood right now.
NASDAQ: HOOD
Key Data Points
The lofty valuation being afforded to Robinhood also has to be placed into a historical context. The company's customers tend to be younger. The stock didn't start trading until after the bear market that came along with the coronavirus pandemic in 2020. So the stock has only been public during a bull market. And the company's customers have never experienced a deep bear market, such as those that occurred during the Great Recession and the dot-com bubble.
If history is any guide, investors will panic and sell stocks during a bear market. That's good for trading activity. However, if the bear market is deep and long enough, many of Robinhood's relatively young customers may decide that investing is too risky. It would be a normal reaction and one that has happened before on Wall Street. Robinhood will likely survive such a downturn, but it seems likely that the valuation premium it is currently being afforded won't. That's particularly true if its customer base shrinks along with stock prices during the next bear market.
Most investors should probably avoid Robinhood
Robinhood has done some impressive things in its short existence. That notably includes forcing the entire industry to lower trading costs. However, it appears that investors have already factored in a significant amount of good news into the stock, despite the 20% drawdown. Unfortunately, the real test of the business won't be known until after the next deep bear market. Most investors should probably wait to see what happens when the market declines (and then declines still more) before considering this innovative discount broker.
