Robinhood REVEALS Their Sneaky Business Model... (Robinhood IPO Filing)

Well, a couple of weeks ago, the commission-free trading app Robinhood submitted their S1 filing to the SEC, which is the initial registration form for new securities based in the US. What this means is that yes, Robinhood is gearing up for their IPO, which is, of course, their initial public offering. This is a process where a private company sells new shares to the general public for the first time and thus raises some juicy cash in the process.

But why this S1 filing is so interesting is because there's been a lot of criticism around Robinhood's business model recently, and in the S1 form, all cards get laid out on the table for all to see. It's basically a document explaining everything that potential investors will need to know about that business. However, it's also about a million pages long, but that's why I'm here.

So in this video, we're going to look into exactly how Robinhood is making their money and whether it's a business that I think is worth following. So let's get started. This video is sponsored by Hyper Charts. Sign up to Hyper Charts using the referral code "new money" or use the referral link in the description and save 10% for your first year of Hyper Charts Premium.

So Robinhood, they are gearing up for their IPO and are going to be trading on the Nasdaq under the ticker symbol HOD. So let's have a look at their business. As you may or may not know, their app looks like this: whoopty-doo! It's a brokerage free trading app. You can buy stocks, options, and crypto, and it costs you absolutely nothing.

Notice anything wrong with that statement? Here's something to note about businesses that seem to provide a service for free: it's not free. They're a business; they need to make money. And if you, the customer, aren't giving them money, then guess what? You're not the customer; you're the product. And that is true with Robinhood's business as well, which we'll talk about a little bit in a second.

But Robinhood, it is a company in essentially an explosive growth mode. Check this out: there are now 18 million Robinhood accounts, which is insane because if we rewind the clock just 12 months, they had just 7.2 million accounts. How's that for growth? Pretty impressive. They also have 17.7 million people using Robinhood at least once per month, which is up from 8.6 million people a year back.

Interestingly, if you add up all of the stock, options, stock positions, and crypto held by Robinhood users, Robinhood currently holds 80.9 billion in assets on behalf of their users. Meaning that the average Robinhood user has a portfolio worth approximately four and a half thousand dollars in total.

Now, in terms of business performance, total revenue in 2020 was 959 million versus 278 million in 2019, so enormous growth there. However, operating expenses also grew to 945 million from 384 million in 2019. So that left Robinhood with a net income of 7.5 million in 2020. Pretty much nothing, although much better than the negative 106 million, which was their 2019 net income.

So it's a business that's early on, you know, growing fast and seemingly just getting to a profitable stage. Now, they have 1.4 billion dollars in the bank right now. They have 10.8 billion in current assets, 8.8 billion in current liabilities. They have a current ratio of 1.2. They don't have much in the long-term sections of their balance sheets, so total assets and liabilities look much the same there.

So they're not in, you know, an enormous pickle or anything like that. They just want to raise some more money and fuel the growth that they're seeing. Now, one interesting statistic that they did provide in this S1 filing is the average revenue per customer, and I wanted to touch on this because then we can talk about exactly how Robinhood makes their money.

So in 2020, Robinhood did not charge brokerage fees to their users. However, they generated 108.90 in revenue per user. This is up massively from 2019, where they generated 65.70 per user. So that begs the question: where the hell does this money come from?

Finally, this is exactly what Warren Buffett wanted to read about in Robinhood's S1 filing. Have a listen to this: "I do want to see how about how they handle the source of income when they say they don't charge the customer or anything; I mean, you know, it should be interesting to watch out." Describe it, I mean, but interesting indeed!

So how do they explain it? Well, let's have a look. They say, "Our mission to democratize finance for all drives our revenue model. We pioneered commission-free trading with no account minimums, giving smaller investors access to the financial markets. Many of our customers are getting started with less, which often means they're trading a smaller number of shares rather than earning revenue from fixed trading commissions."

Which before Robinhood introduced commission-free trading had ranged from, you know, eight to ten dollars per trade. The majority of our revenue is earned through payment for order flow. There it is: payment for order flow!

So what is payment for order flow? Well, it's where you, as the broker, don't actually execute the trades for your users. Instead, you sell the orders coming in on your platform to a market maker, usually a big hedge fund, and they'll handle the execution for you. But why would the hedge funds pay you for the annoyance of having to execute your users' trades?

Well, it's because if they see what's coming in versus where the market is at, occasionally they can jump on the other side of your trade and make money. It might make it a little bit more expensive for you, but they don't care. Now, Robinhood makes 75% of their revenue by selling order flow. Last year, they sold 720 million in order flow—that's 40 per user per year.

Seems like a lot, and it is because here's the thing: Robinhood gets paid much, much more for their order flow than order flow coming in from other discount brokers. In fact, a 2018 Seeking Alpha report highlighted that Robinhood was getting paid about ten times more than their competitors for their order flow. Why? Because Robinhood's order flow was so damn profitable.

Firstly, the people trading on Robinhood are complete noobs. I mean, even in this S1 filing, Robinhood states that over 50% of Robinhood users are first-time investors. And then secondly, the cherry on top is that Robinhood's default order type is a market order, and to a high-frequency trading firm, that's like a blank check.

Robinhood's users basically saying, you know, "Hey, I've not really done this stocks thing before; can you just buy me some Tesla shares, whatever the price is?" You know, that line that goes up and down? So yeah, no doubt Robinhood users get taken to the absolute cleaners on market orders, but they don't know, and the hedge funds love it.

No order flow like Robinhood order flow. And you might say, "Well, come on, Brandon, this is surely illegal," and yes, that is correct. These third parties must follow the national best bid and offer regulation, but, well, let's just say Citadel, who is a massive buyer of order flow from Robinhood, was fined 22 million dollars by the SEC in 2017 for, yep, violating securities laws.

So that is 75% of Robinhood's business. Of that payment for order flow business, 47% of that revenue is from options trading, 32% is from regular stock trading, and then the rest is from cryptocurrency. So all of that is 75% of Robinhood's total revenue.

Then from there, another 18% is from interest payments from these novice investors trading on margin, and then the last seven percent of their revenue is from Robinhood selling their gold subscription service. So there you go, Warren, that is the breakdown of how Robinhood makes money and how their business works.

So overall, what do I think? Is Robinhood a stock that might end up on my watch list? Honestly, I can't say that it will. As you can probably tell, I do have a bit of a problem with their business model. I mean, I like that they are trying to offer a service that enables everyday Joes to invest, but I also think they do it in quite a dangerous way.

For example, offering access to options trading or margin accounts when they know and publish that over 50% of their users are brand new to investing. And the thing is they make roughly 35% of their revenue from people trading options; 18% of their revenue comes from people opening margin accounts.

So there's an incentive there for them to continue pushing that side of their business, which I think is dangerous for new investors without that understanding or experience. But beyond the business model, unfortunately, I think there's just too little financial information to make a proper decision from.

I mean, Robinhood was only founded in 2013, so there's not a long history anyway. Yes, they've done very well to get to where they are today, but in the S1, we've really only got two years of data for most metrics, which just isn't enough to be able to confidently stick a future growth rate on this business.

I mean, it would be practically impossible to accurately value this company. Beyond that, it's a business that has really only just started making money, and that may change over the next few years with expansion. They may be profitable some years, then in the red during other years. They may raise more money in the future, which might dilute shareholders.

It's just, it's very difficult to model how this thing is going to play out. And Warren Buffett's rule number one of investing is don't lose money. So if you're not sure that you can follow that rule, it's best to just put it aside, move on to the next one. And honestly, that's why I personally don't buy any IPOs.

I'm obviously not saying that you guys can't or shouldn't. Ultimately, it's your money; do what you like with it, but that's my reasoning as to why I'm personally staying away: issues with the business model and a lack of clarity as to their future growth and future cash flows.

Anyway, guys, that will do us for today. They are my thoughts on Robinhood's upcoming IPO and their S1 filing. I hope you got something out of this video; I hope maybe it helped you understand really how their business model works and how they make money. It's a little bit tricky to understand, but I hope I've done an okay job at explaining it.

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But that will just about do us for today, guys! Thank you very much for watching. If you wanted to see how I go about my investing, the Warren Buffett strategy, you can check out the links down in the description. That will take you over to Profitful, which is the business that I started. I've got two in-depth courses: one about passive investing, one about active investing—that's in the description if you would be interested in checking that out.

But I think that just about does it for today, guys. Thank you very much for watching, and I'll see you guys in the next video. Hey guys, thanks for watching the video, and thanks to Hyper Charts for sponsoring this video. If you're a stock market investor and you are not using Hyper Charts, I would seriously recommend you check them out.

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