The humble beginnings of a disruptive zero-commission app
Robinhood is the first zero-commission online trading platform in the brokerage industry. After attending Stanford, Baiju Bhatt and Vlad Tenev formed Robinhood—originally known as Spacetime Industries—in 2013. Their idea was to build a financial services network that democratized financial services for all, in the spirit of the post-financial crisis Occupy Wall Street Movement. But looking after the progress that financial infrastructure has made a unique stock trading app was born, one that capitalized on the emerging mobile ecosystem to draw a new generation of digital natives.
Robinhood as we know today, is a FINRA-regulated broker-dealer that is also a member of the Securities Investor Protection Corporation. It is also registered with the US Securities and Exchange Commission. The business achieved a first-mover advantage known for providing commission-free stock and ETF trades through a mobile app that was launched in March 2015. The company has confidentially filed for its IPO.
Headquarters: Menlo Park, CA
Notable Investors: Index Ventures, Sequoia Capital, and New Enterprise Associates.
Capital Raised: $5.58 Bn
Offer Price: $60.00 (April 2021)
Ticker Symbol: ROBN or HOOD
A customer-centric technology building the growth story
The platform gained 13 Mn users since its inception in 2013. In the first two months of 2021, it added another 6 Mn users. The marketing slogan for Robinhood is “democratize finance.” Although this is largely marketing hyperbole, it has resonated with consumers, especially during the Covid-19 pandemic. Lockdowns, boredom, and government stimulus reviews have all been blamed by analysts for attracting a large number of new users to the app in the last year. The number of weekly downloads from US app stores increased dramatically in the first half of 2020, making it the fourth most popular finance app in the nation.
According to the industry news platform Business of Apps, the average account size is about $3,500, compared to $100,000 for E-Trade and $240,000 for Schwab. Despite the common myth about naive traders buying stocks on the spur of the moment, Robinhood’s army of new investors has done very well, at least in the aggregate. Ivo Welch, a finance professor at UCLA, recently published a paper that looked at the behavior of thousands of Robinhood traders during the bear market in March 2020 and over the previous three years. He discovered that traders on Robinhood appeared to make rational decisions.
The influx of new customers at Robinhood has sparked a lot of buzz on Wall Street. According to reports, the company was estimated at $12 Bn in September 2020, increasing to about $20 Bn by the end of the year, and then doubling to $40 Bn in February 2021 as the market sentiments applauded on the news of an upcoming IPO.
Not your regular subscription-based Revenue Model
Robinhood’s business model is based on “paying for order flow,” which means they don’t charge users to position trades or make any sort of fee. Payments for order flow are payments that Robinhood charges for executing orders through market-makers, who are high-frequency trading companies that keep a large inventory of shares and function as a kind of middle man between investing apps and the actual market. These companies pay public-facing broker platforms for the ability to exchange. Robinhood also offers a $5 per month premium option called Robinhood Gold, which allows users access to a $1,000 trading margin. The company hasn’t disclosed if the feature is profitable.
Rapid growth at the price of increasing pain
Day trading is a very difficult way to make money in investing, according to reams of analysis. It’s no coincidence that Robinhood’s users are enticed to trade regularly and potentially take on more risk than they can handle, which can lead to catastrophic outcomes. Since it generates some of its revenue by selling order flow, it’s in Robinhood’s best interests to increase trading volume. This obscure business practice entails a trading website, such as Robinhood, auctioning off its clients’ market orders to high-frequency traders, who then pay to fill them. The practice is technically legal, but the Securities and Exchange Commission is reportedly looking into it. The ongoing GameStop drama exemplifies Munger’s accusation. Individual investors have poured money into thinly traded meme stocks, pushing some to absurdly high valuations based on nothing more than speculation. While Robinhood is far from the only forum used to trade speculatively, it has become the face of the trend.
Competitive pressure and stringent regulations dwindling the trust of clients
Despite having a broad and active client base, one of Robinhood’s biggest challenges would be persuading people to trust it with a greater portion of their investment portfolio. It currently has an average total per client balance of about $1,500, compared to $135,000 for competitors such as Charles Schwab. This confidence is difficult to earn, and the company hasn’t helped matters by positioning its app at the lower end of the market while still offering the same complicated products that more knowledgeable investors would use.
Robinhood recently experienced a series of significant outages due to the coronavirus pandemic, which has resulted in many investor lawsuits. Last year, Robinhood was also the subject of a civil fraud investigation for failing to report its payment for order flow practice. In December 2020, Robinhood agreed to settle with the Securities and Exchange Commission, paying a $65 Mn fine. Without addressing these problems, Robinhood would be unable to compete with the major players and gain market share among professional clients. Robinhood was fined $1.25 Mn by FINRA for failing to guide transactions so that its customers got the best rates.
Without addressing these problems, Robinhood would be unable to compete with the major players and gain market share among professional clients. Robinhood, on the other hand, remains a strong favorite among millennial investors.
Market sentiments driving the valuations upwards
Robinhood has raised over $5.6 Bn in funding since 2013, enabling it to continue to grow at a rapid rate. Although the pandemic wreaked havoc on many businesses, Robinhood and other investment platforms saw a surge in demand as institutional investors flocked to the stock market in the hopes of a recovery. It’s no surprise, then, that Robinhood plans to take advantage of the stock market’s euphoria by launching an IPO in the second quarter of 2021. Investors will have to wait to see how much the company is worth, but it will almost definitely be more than the $11.7 Bn it raised in the most recent funding round in September 2020 – which raised $460 Mn. According to recent estimates, the company may be worth $40 Bn.
Analyzing the Competitive Landscape
Despite the fact that many industry mergers have reduced the number of competitors, the table below compares Robinhood to a few other US investment platforms using April 2021 results.
Fundamentally, the current valuation for Robinhood would approximately be equal to 12x-17x NTM, keeping a holistic view of positives together, when we establish listed and successful comparables like Charles Schwab and eToro. Although the current market valuation as per some experts is $40 Bn, in the longer run we believe, that the markets will correct itself and the valuation is likely to take a slump as it is overvalued due to the short-term positive macro factors that are pushing the key business drivers. The intrinsic valuation shall range between $8 Bn – $12 Bn as per prudent estimates.
eToro, another trading and investment app focused on inexperienced traders, is one of Robinhood’s main competitors. eToro has 20 Mn users, which is 53.8% more than Robinhood, according to a press release from March 2021. eToro is also planning an initial public offering in 2021.
Robinhood is evolving into a deceptive crypto bet. In the first quarter of this year, 9.5 Mn users exchanged cryptocurrency on the company’s site. Just a few trading platforms allow users to buy stocks and bitcoin at the same time. Even though Robinhood does not enable users to move their crypto outside of the network, it profits from the cryptocurrency boom. Robinhood collects the spread on the bid-ask, which can be as high as 2%, in addition to a trading fee on crypto transactions.
Is Robinhood profitable?
In 2020, Robinhood made $682 Mn in payment-for-order-flow sales. This is a 514% rise from the previous year. It’s unsurprising that Robinhood’s sales are increasingly increasing, given that the company had over 13 Mn users in early 2020 (probably closer to 20 Mn now), all of whom will be receiving Robinhood commission from market makers. Particularly because Covid-19 has wreaked havoc on the stock market.
Given that this represents just 40% – 50% of Robinhood’s overall income, we can estimate the final figure to be about $1.3 Bn. PFOF brought in $330 Mn for Robinhood in Q1’21. Here’s the breakdown:
• Options: $197 Mn (60%)
• Non-S&P 500 Stocks: $126 Mn (38.1%)
• S&P 500 Stocks: $7.1 Mn (2.2%) this represents a 263% YoY and 49.5% QoQ increase in PFOF revenues.
Is it worth investing in Robinhood?
It’s important to keep Robinhood’s entire story in context. Despite the fears of a billionaire nonagenarian, the GameStop squabble did not lead to Robinhood being what it is today. Although the app has run into some regulatory issues, this isn’t an unusual occurrence for fast-growing startup companies. However, there are enough questions that you may be hesitant to make a purchase. Another important part of the tale is this: Robinhood operates in a highly competitive environment, and its rivals aren’t going anywhere anytime soon. TD Ameritrade was recently acquired by Charles Schwab for $26 Bn. E-Trade was purchased by Morgan Stanley. WeBull, a Chinese-owned investing app, is attempting to replicate Robinhood’s gamified app investing strategy. Stock exchange, last but not least, is a commodified market. End-user prices are as low as they come: essentially zero.
Since then, Robinhood has set itself apart by allowing investors to purchase Bitcoin and other cryptocurrencies, but other players—Coinbase, Paypal, and Fidelity, to name a few—are still major competitors in that sector. Robinhood would have to keep growing in order to justify its exorbitant valuation. However, if the frothy stock market collapses, this could be difficult. With the exception of the historically rare pandemic crash and rebound in February and March 2020, newest investors have only seen bull markets. However, the trend is expected to repeat itself for the next couple of years. This streak of good fortune contradicts the previous history: Socks famously had a bad decade in the 2000s. What happens to investors’ risk appetite during a typical recession? Since Robinhood hasn’t proven capable of coping with such a scenario, cautious investors should limit their exposure to the business.
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