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Alphabet (GOOG) reported a massive gain in its free cash flow (FCF) for Q2, up 73% YoY from $12.59 billion to $21.778 billion. That was even 26.5% higher than its Q1 FCF of $17.22 billion. This means GOOG stock, at $133.01 on July 28, is still too cheap, despite a recent runup prior to the earnings release on July 25.
It also means that buying long-term call options and shorting near-term out-of-the-money put options is still a very good income strategy for long-term GOOG stockholders. That is especially the case since Alphabet still does not either pay dividends.
On the other hand, Alphabet has been repurchasing large amounts of its shares. That is a very good use of its free cash flow and works out to their benefit in the long run.
For example, last quarter Alphabet spent $29 billion on share buybacks. At an annualized rate ($118 billion), that works out to almost 7% of its $1.689 trillion market capitalization (i.e., $118.1 b/$1,688.8 b = 6.99%).
Free Cash Flow Reigns
FCF is the amount of revenue left over after all its cash expenses as well as its capex spending (which is not deducted on the income statement). Moreover, FCF also deducts changes in working capital (also not deducted).
So, in effect, this “leftover” cash flow is “free” to be spent on discretionary things like acquisitions, dividends, buybacks, etc. That is why Alphabet's FCF is so important since it funds the company's massive buyback program.
As it stands, Alphabet's valuation does not reflect this powerful free cash flow. If we annualized its 21.778 billion Q2 FCF it works to a 5.1% FCF yield (i.e., $87.1 b/$1,688.8 b). This is a higher FCF yield than other comparable stocks (i.e., that means GOOG stock is too cheap).
For example, Microsoft (MSFT) reported about $19.8 billion in FCF in Q2, or $79.3 billion on a forward annualized basis. However, since MSFT stock has a $2,515 billion market cap, its FCF yield is much lower at 3.15% (i.e., $79.3 b/ $2,515 b).
This implies that GOOG stock could have a higher valuation on a comp basis. This can be seen by dividing its $21.778 billion FCF (actually $87.1 billion on an annualized basis) by the 3.15% FCF yield from MSFT stock. That produces a market cap of $2,765 billion. This is 63.7% higher than its present market cap of $1.689 trillion.
That implies that GOOG stock could rise 67% from $133.01 today to $217.88 per share. Traders can use that target price to make good options trades.
Long Call and Short Put Options Strategies
Assuming GOOG stock will rise 67% to $218 over the next year, bullish traders can afford to pay a reasonable premium for call options that expire in the next 4 four months or so. For example, the Nov. 17 call options for the $155 strike price, which is 16.5% over today's spot price of $133.01, trade for just $2.02 per call.
That makes the breakeven price at just $157.02, or 18% over today's price. But if the trader believes that GOOG stock is worth well over $200 (i.e. $217.88 target price), paying that premium for an option that does not expire for 111 days could be worth it.
For example, let's say that the stock starts to approach $180 per share by the end of Oct. That means that at the minimum the call option would be worth $25.00 (i.e., $180-$155) on an intrinsic basis. Moreover, the actual call premium will be higher due to extrinsic value since there is still time left for its expiration.
But the bottom line is that assuming GOOG stock rises 35% to $180, the call option buyer today would make at least 11x their investment (i.e., $25/$2.02-1).
Another way, perhaps in combination with this strategy, is to short out-of-the-money put options. That produces income that could be used to pay for the long-call options that are bought.
For example, for the option expiration period ending Aug 25, 27 days from now, the $130 strike price puts trade for $2.76 per put contract. This works out to a 2.12% yield (i.e., $2.76/$130) and more than pays for the $2.02 long call option premium, with 74 cents per contract left over.
This means that the investor first secures $13,000 in cash and or margin (including from owning any GOOG shares) with their brokerage firm. Then they can then enter an order to “Sell to Open” 1 put contract at the $130.00 strike price
As a result, the brokerage account will immediately receive $276, which works out to a 2.12% yield on the $13,000 investment. That $276 can then be used to purchase one call option for $202 at $155.00 for expiration on Nov. 17. In effect, then, the call option purchase is free and clear.
The downside risk is if GOOG stock falls by over 2.2% to $130 or lower. Then the $13,000 held in cash and/or margin will be exercised and automatically used by the brokerage firm to force a purchase of 100 shares at $130 per share. That may or may not result in an unrealized loss. Nevertheless, the trader still owns the 1 call option, having paid for it with the income generated by the short-put play.
Moreover, at that point, the investor can short near-term out-of-the-money calls to help cover any potential unrealized loss.
This shows that there are good ways to play GOOG stock, given how cheap it is due to its powerful free cash flow.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
