Broadcom Looks Deeply Undervalued Given Its Massive Free Cash Flow Margins

Broadcom (AVGO) recently released impressive results for its fiscal Q3 ending July 30. The semiconductor company reported a massive free cash flow (FCF) of $4.6 billion. This could push AVGO stock significantly higher. 

Moreover, given that the stock has recently shown weakness, this provides a great opportunity for value buyers. In addition, given very high put option premiums, it makes sense to short out-of-the-money (OTM) puts to gain extra income.

Massive FCF Margins

Broadcom reported that its revenue was just $8.876 billion, up 5% for the quarter. However, given that its FCF was $4.587 billion, that means its FCF margin was a sky-high 52%.  

Here is what that means. After FCF is the net result after deducting all of the company's cash expenses, as well as all of its capex spending and changes in working capital. The latter two items are not shown on the company's income statement. 

That leaves the remaining cash flow “free” to be spent on anything the company wants, such as dividends, buybacks, acquisitions, etc.

In other words, over 50% of every sales dollar goes straight into the company's bank account unhindered by any cash obligations. This is one of the highest FCF margins in the stock market.

Broadcom's Valuation

The company's huge FCF has major implications for its market valuation. For example, let's assume that analysts' forecasts of $38.67 billion in revenue for the year ending Oct. 2024 come to pass. 

This would be an increase of 8.0% over analysts' $35.8 billion sales forecasts for Oct. 2023. But more importantly, we can forecast FCF for the coming year.

For example, to be conservative let's assume that just 50% of revenue for the year ending Oct. 24 converts into free cash flow. That implies that Broadcom could still generate $19.35 billion in FCF.

We can use that figure to estimate its true value. For example, using a 4% FCF yield, the stock's market capitalization could eventually reach $483 billion (i.e., $19.335b/0.04). This is also the same as multiplying the FCF by 25x since the inverse of a 4% yield is a 25x multiple.

That is $141 billion higher than its present $342.19 billion market value (i.e., a potential gain of 41%). But to be even more conservative, let's use a 5% FCF yield (i.e., multiply FCF by 20x). This results in a market cap of $386.7 billion. That provides an upside of 13%.

In other words, on average we can expect that AVGO stock could rise between 13% and 41% over the next year. That gives us a 27% higher price target of $1,052 (i.e., 27% over today's price of $829.08, as of Friday, Sept. 22).

Shorting OTM Puts for Extra Income

Broadcom pays a good dividend of $18.40 per share and it's likely to increase that per share amount sometime in December. This is because the company is generating well enough cash flow to cover this payment. It also has had 12 consecutive years of raising its dividend.

However, this gives investors a dividend yield of just 2.22%. One way to increase the amount of income from AVGO stock, while waiting for the price to rise, is to short out-of-the-money (OTM) put options in near-term expiration periods.

For example, look at the Oct 13 expiration period, just 2 weeks from today. It shows that by selling short put options at strike prices 5% or so below today's price can yield 1.0%. That actually works out to an astounding annualized expected return (ER) of over 17%.

Here is how that works. Look at the option chain for Oct 13 - specifically the $785 and $790 strike price premiums. They trade at $7.80 and $8.60 per put contract.

AVGO Puts - Expiring Oct. 13 - Barchart - As of Sept. 22, 2023

This means that anyone who secures $78,500 and $79,000 respectively in cash and/or margin with their brokerage firm can enter an order to “Sell to Open” one put option contract at those strike prices.

The account will then immediately receive either $780 or $860. That works out to 0.99% and 1.088% respectively. 

If this can be repeated every 3 weeks for a year, the account will make an ER of $13,260 in income at the $785 strike price (i.e., 16.89% on the $78,500 invested) and $14,620 (i.e., an ER of 18.50% on the $79,000 invested).

Now keep in mind that these strike prices are 5.32% and 4.71% below today's price. That means they are deep out-of-the-money (OTM). In other words, AVGO stock would have to fall by about 5% on average before the short-put trades would even be exercised - i.e., the investor's secured cash would be used to buy the stock at the strike prices.

That is why it makes sense for existing shareholders to take advantage of these high put strike price premiums. They can collect the income while they wait for the stock to rise.

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.