Should You Buy Robinhood (HOOD) Stock?

Robinhood Markets Inc. (ticker: HOOD), the popular stock-trading app for retail investors, will debut its initial public offering (IPO) on Thursday, July 29, planning to offer 55 million shares at $38 to $42 per share, implying a roughly $35 billion valuation.

But will Robinhood stock be a good addition to your portfolio?

At the beginning of 2021, Robinhood became a household name as it helped fuel meme stock mania and saw its monthly active users more than double from 8.6 million in the first quarter of 2020 to 17.7 million by the end of the first quarter in 2021.

Yet, this influx of new investors also brought significant regulatory pressures. On Jan. 28, Robinhood suspended users' ability to buy shares of certain stocks, initially citing recent market volatility but later admitting that it did not have enough cash reserves to fulfill demand.

While the decision to suspend trading angered users and drew bipartisan condemnation from Capitol Hill, they say all press is good press, and the decision boosted Robinhood's public profile while also revealing a clearer explanation for how the company actually conducts zero-commission transactions.

Excited investors see momentum from early 2021 as indicative of Robinhood's future growth potential and a sign that a new age of investing has arrived. However, detractors cite looming regulatory issues, large and established competitors, and an undiversified product line as reasons Robinhood stock might not be the best investment.

With Robinhood going public, consider the following points before you invest in HOOD stock:

Robinhood Stock at a Glance

After graduating from Stanford University, roommates Vladimir Tenev and Baiju Bhatt moved to New York City and sold trading software to hedge funds. The two soon realized, though, that these big Wall Street firms pay a pittance to conduct their stock transactions while everyday investors face significant commission fees.

Angered by this dynamic, Tenev and Bhatt set out to create a better system, eventually developing a stock-trading app and naming it Robinhood.

They modeled their interface and platform after social media companies like Facebook Inc. (FB) and Twitter Inc. (TWTR), offering a free service on a beautiful and clean interface.

Today, Robinhood offers zero-commission trades with no minimum balance, getting most of its revenue via microscopic payments from market-making firms, and its interface has replaced confusing financial jargon with simplicity and slang. Seconds after downloading, anyone can begin investing in a variety of financial instruments including stocks, funds, options, gold and cryptocurrency.

What's more, the platform offers a variety of other features, including the Robinhood Snacks newsletter and podcast; Robinhood Learn, which provides primers and guides for new investors; and Robinhood Gold, a premium, fee-based account that provides access to Morningstar research and margin investing.

True to form, Robinhood has continued to buck traditional financial norms during its IPO process.

Before an IPO, most companies go on a "roadshow," where, behind closed doors, they answer questions from institutional investors interested in buying their shares at the IPO price. Often, all of a company's offered shares will be bought by these firms before retail investors have a chance to purchase, effectively cutting them out from buying in at the IPO price.

Robinhood instead opening its event to questions from the public via a live stream. The platform is also offering users the chance to buy up to 35% of Robinhood stock at the IPO price, a dramatic shift in philosophy from the usual allocation methods, in which 1% to 3% of shares are left for retail investors.

If the way Robinhood's management handles their IPO is any indication of how they will manage a new public company, expect Robinhood's future strategies and products to cut strongly against the grain of mainstream financial institutions.

Pros of Buying Robinhood Stock

Robinhood's IPO momentum runs parallel with the rise of retail investing. Between 2010 and 2020, the number of individual investors surged, with retail trades making up 20% of all equity trading volume in the U.S. in 2020, more than double 2010 levels.

Inside of this demographic, 30% place their orders using a mobile app, and that number grows to 59% when looking solely at 18- to 34-year-olds, according to data from the Financial Industry Regulatory Authority. If you're thinking about buying HOOD stock, this means market penetration is good, but there's still a lot of room to grow.

This rise in retail investing has translated well for Robinhood. In 2020, the platform garnered more than half of all new app downloads for mobile investing and trading platforms, competing against name brands such as Morgan Stanley's (MS) E-Trade, Fidelity Investments, Charles Schwab (SCHW) subsidiary TD Ameritrade and others.

Between 2019 and 2020, Robinhood's transaction-based revenue grew more than 320%, and in the first quarter of 2021, Robinhood recorded transaction-based revenues of $522 million, a 309% increase from the same period a year earlier.

That meteoric expansion won't keep, but Robinhood still believes it has ample room for growth. "Retail investing is a trend that's here to stay," Robinhood CFO Jason Warnick said at the company's virtual roadshow.

In recent years, Robinhood has worked to increase its offerings of financial assets and products. In February 2018, the platform began letting users trade cryptocurrency, including Bitcoin, Dogecoin, and Ethereum. Their percentage of revenue from cryptocurrency grew from 4.4% in first quarter 2020 to 20.8% in the same period of 2021. Other products include their cash management account, a Robinhood-branded debit card that currently has 3.4 million card holders.

Looking forward, Robinhood has teased entering the market for retirement accounts. "We want to make first-time investors long-term investors," Tenev said during their roadshow live-stream, and "are interested in building more accounts types, including IRAs and Roth IRAs."

While no formal plan has been announced, at the end of March 2021, Americans held $12.6 trillion in IRAs.

If Robinhood can capture just a small percentage of that market, retirement accounts could become a major revenue driver for the platform, bringing in long-term investors, as opposed to short-term retail traders.

Cons of Buying Robinhood Stock

Now for the bad news.

While revenue and user growth soared in early 2021 and fueled much of the momentum behind Robinhood's decision to go public, investors are seriously concerned that revenue and user growth has already peaked.

In fact, on a month-by-month basis, the number of both daily and monthly active users actually decreased in March 2021, after peaking in February.

In late 2020 and early 2021, a combination of zero-commission trades, quarantine free time, and government stimulus checks drove many people to retail trading. Those pandemic-sparked catalysts can't be relied on to spark further growth.

Although Robinhood hasn't released figures for the second quarter of 2021, "there was a material reduction in trading volumes," according to Morningstar analyst Michael Wong, who notes that a key factor for future profitability will be "how long their rapid growth can be sustained."

In terms of profitability, Robinhood got a taste during 2020, booking profit of $7.4 million on $958.8 million of revenue. Yet, the first quarter of 2021 saw a return to losses for the platform, as it booked net losses of more than $1.4 billion.

Much of this loss can be chalked up to regulatory issues. In January 2021, the company experienced surging trading volume and the National Securities Clearing Corporation, an independent body that finalizes equity transactions, mandated that Robinhood raise more than $1 billion to hold in reserve.

Robinhood can offer zero-commission trading by routing users' trades to market makers, such as Citadel Securities and Susquehanna International Group, through a practice called payment for order flow (PFOF). These market makers, as a thank you, pay a tiny amount to Robinhood, which becomes the company's transaction-based revenue.

In the first quarter of 2021, 80.5% of Robinhood's revenue was transaction-based, coming from PFOF payments from market makers. Yet in June 2021, Securities and Exchange Commission Chairman Gary Gensler announced that the regulator was reviewing the practice, saying it could create a conflict of interest for brokers and noting the practice's ban in the U.K.

In short, the fate of Robinhood stock may be largely determined by regulators.

"If PFOF is ever banned, we don't believe Robinhood could continue offering commission-free trading, which would put the company at a significant disadvantage to rivals Fidelity and Charles Schwab," equity research firm New Constructs wrote in a recent research report.

"Fidelity and Schwab can afford to continue offering free stock trading without the PFOF revenue thanks to their ability to leverage superior scale to generate meaningful revenue from other services, like asset management," New Constructs writes. Fidelity Investments and Charles Schwab each have more than $6.5 trillion in assets under custody, with average assets per account well into the hundreds of thousands, while Robinhood has a mere $81 billion in assets under custody with an average account of about $500.

Into the future, it seems unlikely that Robinhood will ever be able to meaningfully compete with the major brokerage firms and will likely continue to operate within a niche market, garnering Christmas and birthday checks from Grandma, but not her retirement account.

Bottom Line: Should You Buy HOOD Stock?

Robinhood makes a strong case for future performance in its S-1 filing, pointing to exponential growth between 2020 and 2021 and a new age of retail investing while doubling down on its commitment to "democratize finance for all." But, the pundits have not been as kind.

Famed investor and Berkshire Hathaway Inc. (BRK.B, BRK.A) executive Charlie Munger has called Robinhood "a gambling parlor operating as a respectable business," while New Constructs cautioned that "investors may have better odds of making money by trading risky meme stocks using Robinhood's platform than by purchasing Robinhood's overpriced stock itself."

With looming regulatory concerns and an intensely competitive brokerage landscape, Robinhood's $35 billion valuation seems wildly excessive. Investors interested in buying Robinhood stock should strongly consider waiting until the post-IPO buzz subsides in hopes of finding an entry point that's more in line with the company's fundamentals.