Better Growth Stock: Robinhood vs. Mastercard

Wall Street is an emotional place, with a good story often lifting stocks to lofty heights. Sometimes, prices don't actually line up with business success, which can lead some stocks to become very risky investments.

When you are looking at growth stocks like Robinhood Markets (NASDAQ: HOOD) and Mastercard (NYSE: MA), you need to make sure the story hasn't outstripped the actual potential of the business. Here's why going more conservative in this pair will likely be the better option for most investors.

What does Robinhood do?

Robinhood is basically a brokerage house. But it is an important one because it pioneered free trading, which upended the discount brokerage industry. The success Robinhood had in attracting clients forced other brokers to offer free trades, too. But along the way, Robinhood managed to create a substantial business that has now branched out into other areas, including crypto.

Essentially, Robinhood is at the cutting edge of the finance industry, which has allowed it to grow its business very quickly. Although the company only held its initial public offering (IPO) in mid-2021, revenue has increased over 150% over the past three years. That's impressive growth, even though it came off a small base.

What does Mastercard do?

Mastercard is a payment processing company, supplying the payment network that supports the use of credit and debit cards. It gets paid a small fee for every transaction it processes. There has been a long trend away from cash and toward card payments, which has supported Mastercard's growth over time. The revenue line of Mastercard's income statement has grown more than 200% over the past decade.

What's notable here, however, is that Mastercard is really just a toll taker. The banks that issue credit cards actually take on the financial risk of what amounts to a short-term loan to their customers. So Mastercard is somewhat insulated from economic downturns. So long as customers keep shopping, which to some extent is necessary, Mastercard's business won't be hit too hard by a recession or bear market.

The risks and rewards of these two stories

The big differentiating factor right now between Mastercard and Robinhood is valuation. Robinhood is a relatively young company that's still building its business. There's material potential for more business growth from here. But at the same time, the stock has risen more than 1,000% over the past three years.

The stock's price-to-sales ratio is 38.5x, which is very high on an absolute basis. And it is well above the stock's five-year average of 6.6x. The current price-to-earnings ratio is 76.5x, which is high on an absolute basis. There's no five-year average because the company hasn't been profitable every year.

Unlike Mastercard, which is somewhat protected from recessions and bear markets, Robinhood's business will likely be directly impacted if there is a period of lower trading volumes. That's not uncommon during recessions and bear markets. So the lofty valuation here could quickly change if the broader story behind the stock changes, noting that recessions and bear markets are normal occurrences.

Given the valuation of the stock, it seems like investors have taken this stock's story to an extreme that requires perfection. It is unlikely that perfection is possible.

Mastercard isn't exactly cheap. Its P/S ratio is around 17.5x today, with its P/E ratio sitting at roughly 39x. But those are both in line with the five-year averages for each metric.

Not only is Mastercard the cheaper growth stock, but its valuation is far more reasonable compared to its own history. And, notably, the history for Mastercard includes year after year of profitability.

Now add in the more protected nature of the business when it comes to recessions, and it looks like a much less risky growth stock choice. And, of course, a bear market won't materially impact the business, even if the stock price falls in sympathy with the market.

Err on the side of caution

Robinhood has done incredible things in a very short period of time. It is also working to take a leading position in the brokerage industry as new markets open up. The story is very exciting.

And Wall Street looks like it has taken that story too far when you consider the stock price advance and the company's valuation. If anything goes wrong, there could be a very deep pullback in the stock price. It is also notable that the company has yet to be tested as a public business, given that it IPO'd after the bear market associated with the coronavirus pandemic.

Mastercard, on the other hand, has a lower valuation and a much more reliable business model. That business has proven it can grow over an extended time period and that it can withstand recessionary environments. The stock's not cheap, per se, but if you compare it to Robinhood, it looks like the more conservative long-term growth option.

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