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Analysts have been hiking Broadcom Inc (AVGO) revenue estimates, which has raised its value. This is based on Broadcom's strong free cash flow margins. As a result, shorting out-of-the-money (OTM) put options works well here.
AVGO is at $239.62 in midday trading on Friday, Dec. 27, 2024. It has risen significantly (+33%) since releasing its FY 2024 earnings on Dec 12, when it closed at $180.66.
At the time, I wrote a Barchart article about how undervalued it appeared: “Broadcom's Huge FCF Margins and Outlook Impress Analysts—Its Value Could Be Higher.” When I wrote the article AVGO was at $216.44, so it's still up 10.8%.
Strong FCF and Higher Valuation
In the article, I discussed how Broadcom could be worth as much as $262 per share, +22.5%. However, since then, its value has risen based on higher analysts' revenue estimates.
I now believe AVGO could be worth as much as $280.83 per share, up over 17% from today's price. Here is why.
Analysts now have revenue estimates for FY 2025 (ending Oct. 2025) at $61.15 billion and the net 12 months (FY 2026) at $70.39 billion. This means the average for the next 12 months (NTM) or so is now $65.77 billion, higher than the prior average of $65.22 billion in my prior article.
As a result, using an estimated 40% free cash flow (FCF) margin, Broadcom may generate $26.3 billion in FCF over the next 12 months or so:
0.40 FCF margin x $65.22 b NTM revenue = $26.3 billion FCF NTM
As a result, using a 2.0% FCF yield valuation metric, the stock could end up with a $1,315 billion (i.e., $1.3 trillion) NTM market value:
$26.3b / 0.02 = $1,315.4 billion NTM market cap estimate
This is 17.22% higher than today's market cap of $1,122 billion:
$1,315.4 / $1,122 - 1 = 1.1723 -1 = 0.172 = +17.2%
As a result, AVGO stock is potentially worth over 17.2% more than today's price:
$239.62 x 1.172 = $280.83 per share
One way to play this is to sell short out-of-the-money (OTM) puts. That way an investor can set a lower buy-in target price and still get paid while waiting.
Shorting OTM Puts
In my last article, I suggested that shorting the $200 strike price put options expiring Jan. 3, 2025, was attractive. This strike price was over 8% below the trading price and the delta ratio was low at less than 15%.
At the time, the bid-side premium was $1.54 per put contract. As a result, the short-put yield was 0.77% (i.e., $1.54/$200.00).
Today, those puts are almost worthless, trading for just 10 cents on the ask side. As a result, the short seller of these puts has made most of the income, in just 2 weeks. It makes sense to roll this trade over.
For example, the Jan. 24, 2025 expiry puts, 28 days to expiration (DTE), have attractive put yields. The $220 strike price put options have a bid-side premium of $3.60 per put contract.
That offers the short-seller of these puts, which are still over 7% below the trading price, an immediate short-put yield of 1.636% (i.e., $3.60/$220.00) for less than one month investment.
Here is what this means. An investor who secures $22,000 in cash or buying power with their brokerage firm can enter a trade to “Sell to Open” 1 put contract at the $220.00 strike price expiring Jan. 24.
The cash secured for this play acts as collateral if AVGO falls to $220.00 and the account is assigned to buy 100 shares at that strike price.
But, in return, the account immediately receives $360 in cash. That results in an immediate yield of $1.636% (i.e., $360/$22,000).
Downside Risks and Issues
Moreover, as long as the stock stays over $216.40 (i.e., $220.00 - $3.60), or almost 10% below today's price. In other words, there is good downside protection.
As a result, it pays to wait for the stock to fall. Note that the strike price here has a low delta ratio of just -0.213, or just a 21% chance of this occurring.
Therefore, it makes for existing investors in AVGO to make this play. That way they can gain any upside in the stock and also make a good yield while waiting to potentially lower their average cost in AVGO in case it falls to $220.00 per share.
Moreover, the worst that can happen is that they have to use the secured cash to buy more shares. That could potentially result in an unrealized loss if AVGO falls below the breakeven price of $216.40.
However, the investor can always sell more OTM puts or even covered calls, now that they own 100 shares (if assigned) of AVGO stock.
The bottom line is that Broadcom looks undervalued here. One way to play this, especially on a repeated basis, is to sell short out-of-the-money put options.
