Better Growth Stock: Robinhood vs. Visa

Growth investing typically involves some valuation risk, as Wall Street often bakes a lot of good news into the prices of growth stocks. Long-term investors need to figure out how much of a premium they are willing to pay for the growth they expect from an investment. That's the big story when you compare discount broker Robinhood (NASDAQ: HOOD) to payment processor Visa (NYSE: V).

What does Robinhood do?

Robinhood is a discount brokerage. It has dramatically changed the industry in which it operates, effectively forcing its competitors to adopt its free trading offer. Having built a large customer base with free trades, the company has expanded its offerings as it looks to attract active investors. Some of the more innovative efforts have included cryptocurrency trading and sports betting.

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One of the interesting aspects of Robinhood is that it is still relatively young. The initial public offering (IPO) was held in mid-2021. By that point, the worst of the coronavirus pandemic was largely over for the stock market, meaning that Robinhood's stock has only existed as a public company during a bull market. That's extra important for a broker because trading activity tends to be strongest in bull markets. The business is performing well, but it has not yet been tested by a deep market downturn.

What does Visa do?

Visa, by comparison, has been around for a considerable amount of time. The company held its IPO in early 2008, in the midst of the Great Recession. It is a payment processor that allows consumers to pay retailers with cards bearing the Visa logo. Visa collects a small fee for each transaction it processes. The company's growth has been driven by the move from cash to card payments, a transition that is still ongoing. In fact, the growth of e-commerce is an important driver, as more people are shopping online, which necessitates the use of a payment method other than cash.

While Robinhood's history is relatively short, making it challenging to provide meaningful historical growth numbers, that's not the case with Visa. Over the past decade, Visa's revenue has advanced at an annualized clip of 11%, with earnings rising an attractive 14% a year. There's a good reason why growth investors like Visa's stock.

What are you paying for growth?

Starting with Visa, investors have a fairly good handle on what to expect from this industry-leading company. That growth is priced into the shares, which aren't cheap. The price-to-sales ratio is roughly 18.5 times, the price-to-earnings ratio is 33 times, and the price-to-book value ratio is 17.5 times. What's interesting here, however, is that the P/S and P/E ratios are below their five-year averages, with only the P/B ratio above its longer-term average.

On an absolute basis, Visa is definitely expensive. However, relative to its own historical valuation, Visa appears fairly priced overall. It might be best viewed as a growth at a reasonable price (GARP) stock at the moment. That's likely to be more attractive to investors than Robinhood.

After a massive 280% stock price rally over the past year, Robinhood's P/S ratio is 26.5 times, its P/E ratio is 50.5 times, and its P/B ratio is nearly 13 times. The short history and lack of profitability in the early years of its public life mean there's no five-year average for P/E. However the five year average for the P/S ratio is roughly 7 times, and the longer-term average for P/B is about 2 times.

There are two takeaways for Robinhood. First, it is expensive relative to its own history, suggesting that investors are pricing in a lot of good news. This is true despite the fact that it has never been through a bear market. Bear markets can be particularly difficult for brokers. Second, Robinhood is being afforded an even higher valuation than Visa despite Visa's consistent history of growth.

Investors should probably err on the side of caution

Even if you believe that Robinhood can continue to expand its business at a rapid clip, the stock already appears to price in years of growth. And the valuation suggests that there isn't much room for error, even though investors have no idea how the business will perform during a bear market.

If you are a growth investor, it is probably better to stick with a proven commodity like Visa. While the stock is pricey on an absolute basis, it appears reasonably priced on a historical basis. And it is far cheaper than untested Robinhood.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Visa. The Motley Fool has a disclosure policy.