At the end of the previous article, Dolphin Jun summarized that the business model cannot become a true competitive barrier. The emergence of PFOF is essentially just a price war.

By Q3 2024, when the average assets per new user reach USD 100,000, which directly touches the core user circle of Charles Schwab, the current product services offered by $Robinhood(HOOD.US) will no longer meet the needs of new users, making transformation urgent.

On November 19, Robinhood announced the acquisition of TradePMR. This move indicates that it has realized the significant differences between the needs of new users and those of existing users, and in this regard, Charles Schwab is a good model for Robinhood to emulate.

Therefore, in this article, Dolphin Jun will compare the perspectives and explore Robinhood's future options beyond its commission-free model, as well as the reasonable short-term valuation and long-term dream value corresponding to Robinhood in this future.

The following is the detailed content:

1. Hood's cost-performance advantage is converging

The zero-commission + PFOF model pioneered by Robinhood provides users with a sense of "free," but in reality, it monetizes "commissions" through another form of profit-sharing. In simple terms, the "commission" comes from the profit-sharing of market makers' spread, but at the cost of users' right to obtain the best quotes.

However, the monetization rate of this "new commission" is not high. Comparing the changes before and after Charles Schwab's commission-free announcement (in October 2019, it announced that all stock, options, and ETF trades would be commission-free, excluding futures and offline trades, and prior to this, only some proprietary ETFs were commission-free) with Robinhood shows that it is lower than before.

As the internal trading structure adjusts (the proportion of low monetization rate stocks and monetization rate options trading stabilizes), competition among brokers will continue to narrow the monetization rate gap between them, and the overall industry monetization rate will further decline.

Note that in the above chart, Charles Schwab's current revenue per transaction (commission + PFOF income) appears higher than Robinhood due to service commissions for offline trades, a fee of $0.65 per options trade, futures trading, etc. However, as trading shifts online and other securities reduce commissions, it will gradually align with Robinhood's monetization rate level.

Currently, in terms of PFOF income, Charles Schwab's PFOF fees per options trade are already lower than Robinhood's, and while the fees for PFOF stock trades are higher than Robinhood's, this is mainly due to Charles Schwab users trading a higher number of shares per transaction. If calculated on a per 100 shares or per options contract basis, Charles Schwab's PFOF unit price is lower than Robinhood's

In other words, based on the above quantitative monetization rate data, Robinhood's "cost-performance" advantage still exists to some extent, but it is rapidly diminishing. A similar trend can also be observed from a qualitative perspective:

The user perception of "commission-free" trading may be more pronounced, as the old generation of discount brokers and online brokers have all announced commission-free trading, undoubtedly increasing the difficulty for Robinhood to capture users.

After the industry-wide commission-free trading and the end of the pandemic bull market in 2021, Robinhood's customer acquisition speed rapidly declined, and it was weaker than Charles Schwab.

When the monetization rate continues to decline, the only way to maintain growth in trading revenue is to increase the number of transactions in the commission business. However, Robinhood's average user deposit is less than $10,000, far below traditional brokers and leading online brokers, lacking a "natural advantage" in trading scale.

Therefore, how to leverage users for more trading volume and exert "postnatal effort" becomes crucial. Theoretically, methods to expand trading volume include either lending money to low-asset users to increase leverage or attracting more users, especially those with medium to high assets. In fact, Robinhood has indeed taken this approach.

II. Margin trading is an amplifier of performance fluctuations

Engaging in margin trading allows brokers to increase trading volume while also generating additional revenue. As of the latest 3Q24, margin trading accounted for half of the net interest income, which makes up 42% of total revenue for Robinhood, equivalent to 22% of total revenue.

Margin trading and securities lending is a relatively common derivative business that accompanies securities trading. Theoretically, with proper risk control, brokers can purely profit from the borrowing spread in margin trading, ensuring a profit without loss.

In terms of loan pricing, it essentially consists of the market's risk-free return plus a premium based on the supply and demand tension of the borrowed securities. The ability to identify excess Alpha is not very high; the core of expanding the business mainly looks at the balance of margin and securities lending, which reflects the financial strength of Robinhood.

Below, Dolphin will discuss the comparison between Robinhood and Charles Schwab.

1. Margin Trading

Margin trading is relatively easy to understand, similar to a bank loan business, providing users with insufficient funds with up to double the capital, while users use the purchased securities as collateral.

As a common and universal trading derivative business, Charles Schwab and Robinhood have some differences in the monetization efficiency and actual yield levels of their margin trading businesses.

(1) Two Types of People, Two Styles

In the past year, the revenue from Robinhood's margin trading accounted for 10% to 15% of its total revenue. The margin interest rate generally follows the market interest rate plus an interest premium, but Robinhood often offers relatively more favorable rates than its peers.

Dolphin estimates that Charles Schwab's margin trading revenue share is also 15%, and the yield corresponding to the loan balance is slightly higher than that of Robinhood. However, why can't Charles Schwab indefinitely increase its margin trading business?

Dolphin believes the core reason, aside from the need for margin trading to consider user demand, is that there are inherent differences in margin needs among different user tiers. “ The poor borrow money to trade stocks, while the wealthy manage assets.”

a. The Poor Borrow Money to Trade Stocks

Robinhood's core users have an average account asset of less than $10,000, and the proportion of funds used for margin trading in their asset allocation is quite high. The feeling of the poor borrowing money to trade stocks is quite evident.

b. Wealthy Asset Management

For Charles Schwab in the third quarter, for a single client with $250,000 in assets, the allocation was: 50% in mutual funds, 10% in bonds and other fixed income, and less than 10% in cash deposits, leaving only about 35% of the assets truly used for self-directed stock investment, corresponding to nearly $90,000 in assets From this configuration, it can be clearly seen that a. Charles Schwab users are wealthy; b. 50% vs 35%, wealthy individuals primarily invest in funds before trading stocks.

From the two comparisons, it is clear that for different individual client AUM, the products and services required by brokers are significantly different. Users with higher asset scales naturally do not have a habit of high-leverage operations.

Meanwhile, the average asset of newly acquired users by Robinhood has rapidly increased from less than $5,000 to over $100,000 in the third quarter of this year. Robinhood has begun to seize customers from Charles Schwab, becoming a direct competitor.

As Robinhood gradually penetrates the high-asset customer base, relying on traditional brokerage and financing businesses, it is likely very difficult to attract new users and achieve continued high growth.

(2) Charles Schwab's financing business has a higher gross profit margin: Financial strength leads to confidence.

In terms of funding costs, Charles Schwab has a lower funding cost due to multiple sources of funds. Charles Schwab's funding sources include its own funds, customer deposits (due to having a banking license to attract deposits and lend), and bank loans. In contrast, Robinhood's financing business primarily relies on funds raised during its IPO and external borrowing.

Among Charles Schwab's funding sources, due to its banking deposit business, the funding cost of customer cash deposit accounts is very low, only 1.3%, and currently, the relatively high-cost short-term borrowing accounts for only 9% of total funds.

Most of the idle funds in Robinhood come from Gold users, who currently receive about 5% returns in the high-interest environment. Compared to the financing rate of 6%, the interest margin that Robinhood can earn is too small. One reason is that Robinhood does not have a banking license and cannot access low-interest demand deposits from users.

Ultimately, from the relatively intuitive financing business yield and cost rate, as well as the actual gross profit margin, Charles Schwab appears to be more "composed" in its financing business compared to Robinhood.

2. Margin Lending

Robinhood's margin lending business charges two fees: first, a small fee based on the tightness of the borrowed securities when users borrow stocks; second, users need to make a cash deposit when borrowing stocks, which Robinhood deposits into a specific account to earn interest.

Although it was only initiated two years ago, margin lending revenue currently accounts for 10% of Robinhood's total revenue and is a significant part of its interest income.

Charles Schwab's margin lending business also includes the aforementioned two types of income, but Schwab only discloses the fees for margin lending. Here we assume that the deposit interest rate for margin collateral corresponds directly to the overall yield level of segregated funds and securities.

Ultimately, based on 1) the directly charged margin lending fee rate; 2) the yield rate on margin collateral; 3) the cost of margin lending (the borrowing fees paid to users or other brokers), we can calculate the adjusted total yield rate, income structure, and gross margin level for Schwab's financing.

Comparing Schwab's performance with Robinhood in margin lending:

(1) Robinhood's margin lending income is not advantageous: The scale of securities lent by Schwab is significantly higher than that of Robinhood, but nearly half of it is lent to external institutions (including other brokerage retailers and clearinghouses). Schwab's additional fee rates for margin lending and the deposit interest rates for segregated funds are also higher than those of Robinhood.

(2) However, Robinhood's margin lending costs are lower: Despite Schwab having a better overall income yield than Robinhood, the final net yield rate of Schwab's margin lending business is still lower than that of Robinhood.

This clearly indicates that Schwab's margin lending costs are higher. It is believed that the high costs are mainly due to the fact that Robinhood's stock sources come from its own commission and financing business users' securities, which are either at zero cost or the cost of the stocks is only 15% of the interest charged to customers. However, Schwab has higher-cost upstream borrowing. In internal borrowing, the interest sharing given to users is also higher, at 50%.

In terms of overall comparison of margin lending business, Robinhood is more aggressive in margin lending (the margin balance accounts for a higher proportion of AUM) due to the low monetization rate of PFOF transactions, but due to incomplete licensing, the scale is relatively smaller, and the actual borrowing business interest rate costs are overall higher. But the more important question is, when the trading business faces customer acquisition bottlenecks and the penetration rate of margin financing business stabilizes, what exactly should it do to avoid premature decline? What can it rely on to attract high-net-worth users?

III. What to rely on for future growth?

1. An unavoidable step: step out of the comfort zone and provide higher-dimensional services

Robinhood's success relies on zero-threshold AUM and trading experience to attract novice users. However, the new users with $100,000 accounts acquired by Robinhood in Q3 2024 are not entirely interested in these features.

Perhaps they were attracted by Robinhood's unique features such as commission-free Bitcoin trading and options trading, but merely relying on trading is not enough to retain them in the future. A distinct characteristic of trading users is that once the market cools down, account activity will sharply decline, increasing the volatility of Robinhood's performance.

From the asset distribution of Charles Schwab users mentioned earlier, it can be seen that when wealthier users come in, they are more willing to entrust 60% of their assets to professional institutions for management (such as purchasing funds and fixed income), and they are also likely to purchase advisory services for nearly half of their assets. This indicates that the needs of these users are not just trading, but comprehensive wealth management needs.

To meet the needs of these users and continuously acquire new customers, Robinhood needs to fill the gap in wealth management services. Moreover, as the originally young novice core users grow older and accumulate wealth, they will also develop wealth management needs beyond trading.

Last month, Robinhood took its first step into wealth management—on November 19, it announced the acquisition of an advisory platform TradePMR for $300 million.

This is a middle custody platform connecting independent advisors with clients, and it does not have retail operations itself. Compared to traditional advisory platforms that focus on user needs, TradePMR places more emphasis on the services provided by independent advisors. TradePMR has over 25 years of industry experience and manages assets exceeding $40 billion.

In the view of Dolphin, Robinhood's actions indicate that it has realized the significant differences between the needs of new users and those of old users, and in this regard, Charles Schwab is a good model for Robinhood to emulate.

Since the acquisition of the trust company in early 2000, Charles Schwab has embarked on the transformation from a discount online brokerage to a comprehensive wealth management institution. Wealth management for Schwab is not only a forced transformation under the trend of commission reduction but also a proactive expansion to broaden new customer sources and increase new revenue.

(1) The overall take rate of wealth management business is lower than that of trading business, but during several waves of commission reductions, the income from wealth management has partially compensated for the revenue gap caused by the decline in trading income.

(2) The wealth management business helps the platform stabilize customer acquisition, especially for high and medium asset users. This means that even if there are commission reductions or poor market conditions, Schwab can still utilize the continuous increase in customer assets to invest more idle funds into fixed-income bonds and cash deposits to earn higher interest income.

As for how Schwab's wealth management journey has progressed, Dolphin will focus on this when covering Schwab in the future. Interested readers can continue to follow.

IV. Valuation Imagination Space: User Lifetime Value under the Internet Model

The future value of Robinhood is actually quite complex. Although Robinhood is a financial company, due to its internet attributes and the ongoing growth in customer acquisition and monetization, the capital market generally uses common platform company metrics like EV/Sales or EV/EBITDA, rather than PB.

At the same time, there is a greater tendency to conduct short- to medium-term valuations of Robinhood, based on customer acquisition and revenue expectations for the next 1-3 years. Even during actual trading, there is a preference for more short-term marginal changes.

After all, the securities trading market is unpredictable, and brokers often disclose current operating data in advance of monthly earnings reports. Additionally, retail brokerage is a highly competitive industry, where "big fish eat small fish" mergers and acquisitions frequently occur, making the competitive environment unstable.

In this context, making performance expectations for three years or more is relatively difficult and not very meaningful. However, Dolphin believes that Robinhood's greater imaginative space lies in the future, as the value will gradually be realized in the process of improving the financial ecosystem. From the current standpoint, predicting a company's strategic plan that has not yet been clearly implemented is not reliable.

Therefore, Dolphin believes that in the short term, as Robinhood still leans towards trading attributes, it should be valued based on long-term performance expectations, using the valuation ranges corresponding to past market bull and bear phases. When market sentiment is high and there are marginal benefits for Robinhood, there is room for upward imagination.

(1) Short-term valuation looks at marginal changes

Robinhood has been quiet for two years, but this year, due to AI, meme stocks, and cryptocurrencies strongly promoted by Trump, its performance has rebounded, resulting in a wave of annual-level market activity driven by sentiment.

Dolphin believes that the aforementioned market catalysts are expected to persist in the short-term six-month cycle, especially the uncertain factor of Trump, who may introduce some favorable measures/statements for the cryptocurrency market after taking office at the beginning of the year.

However, at the same time, some concerns revealed in the third-quarter report also exist ( Review and Interpretation ): The penetration of novice users has reached its peak, and competing with giants like Charles Schwab for users will drive up customer acquisition costs, but the wealth management business is currently not yet perfected, which may not be able to retain this portion of users for long; a rate cut cycle will enter in the medium term, and although it benefits from interest rate spreads, the narrowing of spread space during a rate cut cycle will inevitably affect interest income.

Therefore, in the short term, it is recommended to develop corresponding investment strategies around valuation ranges: Since its listing in 2021, Robinhood's central valuation has been around 5x EV/Sales, and it has now reached nearly 10x, which is relatively high.

However, this valuation range may also be questionable, mainly because Robinhood's listing time is too short and it has quickly experienced a bull-bear transition, especially since 2021 was a period of massive liquidity. The performance decline of Robinhood from 2022 to 2023 has led the market to value it even at the level of mature financial institutions, around 2x EV/Sales. Therefore, the past valuation range has mostly been under a pessimistic valuation influenced by both market sentiment and performance, and the overall range should be relatively low.

If we assume that the profit margin differences among different platforms under steady state are not significant, and compare horizontally with peers like Charles Schwab (8x), Interactive Brokers (4x), and the core cryptocurrency target Coinbase's EV/Sales (15x) valuation, Robinhood is also in a neutral to high position, indicating that the short-term sentiment premium brought by cryptocurrencies to Robinhood is too much!

(2) Long-term value: Rely on imagination to play out

Although it is difficult to accurately judge how Robinhood will develop in the long term, if it accelerates the advancement of its wealth management strategy, how optimistic can Robinhood's long-term valuation reach if it grows to resemble Charles Schwab? The expected challenge here is the monetization scale that Robinhood can achieve in the future. Dolphin Jun still borrows the forecasting method of platform-type businesses, using user lifetime value (LTV) * achievable user volume (Users) to make a dream valuation for Robinhood.

We will compare the data from Charles Schwab for discussion, but due to the characteristics of financial platforms, we will adjust the user lifetime value LTV = average revenue per user (ARPU) * lifetime (1/churn rate) slightly to:

User lifetime value LTV = average assets per user AUC * asset monetization efficiency Rev/client assets * (1/churn rate)

Unit asset lifetime monetization value LTV/AUC = asset monetization efficiency Rev/client assets * (1/churn rate)

a. Asset monetization efficiency Rev/client assets

Since the take rate for trading (including margin trading) is higher than that for deposit interest, wealth management, and bank loans, Robinhood can convert a higher income from each dollar of customer assets on average.

b. User churn rate

Within the quarterly cycle, the user churn rates of the two platforms are comparable and very low, reflecting the user stickiness of financial platforms. It is calculated that, under the current marketing and operational efforts, and with the market fluctuations relatively stable, the quarterly churn rate for a user is in the range of 1% to 3%, corresponding to a natural retention period of 8 to 25 years.

Considering that Robinhood's financial services are relatively simple, but it has maintained a lower churn rate than Charles Schwab during the 2022-2023 period, this can reflect the core users' recognition and loyalty to Robinhood, as well as the relatively few direct competitors, with Robinhood's brand deeply ingrained in people's minds. However, since 2024, the churn rate has increased, possibly reflecting perceived changes in competition. For example, the volume of PFOF orders and the number of shares traded delivered to market makers by Charles Schwab have rapidly increased since 2024.

c. Unit asset lifetime monetization value LTV/AUC

The final calculated LTV/AUC shows that Robinhood is higher than Charles Schwab. However, as Robinhood begins to promote wealth management and other businesses, this monetization value will also decline accordingly, but the total value will expand with the increase in user asset scale

Therefore, we assume that in the future, Robinhood will form a financial model similar to Charles Schwab, with LTV/AUC equivalent to the current level of Charles Schwab. Thus, the valuation of Robinhood becomes a prediction of how much user assets Robinhood can acquire in the end:

For example, if it can attract mid-to-high asset users equivalent to 10% of Charles Schwab's users, that would be 3.6 million users, with a net increase of 200,000 users per quarter this year, expected to be achieved in 5 years. After improving the wealth management model, let's assume that these 100,000 self-investing users will also deposit an additional 100,000 and purchase funds and other institutional financial products, meaning the total assets per user would be $200,000. The original low-asset users will see their asset scale increase at an annual growth rate of 10%.

In this case, Robinhood corresponds to an optimistic valuation of $82.4 billion, which, at a WACC of 10%, translates back to $51.1 billion over 5 years (as of December 4, the market value was $35.3 billion), implying a valuation of 17x EV/Sales based on current market expectations for 2025, which is considered a dream valuation at this point!

Although Robinhood's bubble is not yet absurd to this extent, the realization of the dream valuation requires a long journey. This estimation is merely for fun and can serve as a warning line during extreme emotional fluctuations. In the short to medium-term trading cycle, it is still recommended to formulate corresponding strategies based on the valuation range of peers and marginal changes.

Dolphin Investment Research "Robinhood" Historical Articles:

Earnings Season

Interpretation of Q3 2024 Financial Report on October 31, 2024: Robinhood: Is the King of Retail Investors in the U.S. Facing a Tragedy?

In-depth

First Coverage Part 1 on October 12, 2024: “Retail Investor Yihetuan” Robinhood: Is “Commission-Free” Enough to Dominate?

Risk Disclosure and Disclaimer for this article: Dolphin Research Disclaimer and General Disclosure