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Today large, unusual volume of out-of-the-money call options in International Business Machines Corp (IBM) stock is serving to highlight the stock's value. No wonder, as IBM recently raised its free cash flow outlook. As a result, IBM stock looks deeply undervalued here.
IBM stock is at $199.53 in morning trading on Wednesday, Aug. 28. The stock has been rising, especially since it released strong Q2 earnings on July 24.
And no wonder. IBM said it expects to see at least $12 billion in free cash flow (FCF) this year. This is despite the company's extensive AI-related capex investments.
What IBM Stock Could Be Worth
Moreover, the $12 billion in FCF it has forecast represents at least 19% of the $63.2 billion in revenue forecast this year by analysts. This represents a very huge percentage of its market value of $183.86 billion ($12b/$183.86b = 6.53%).
Typically, tech stocks will show an FCF yield of around 3.0%. Moreover, IBM stock has a dividend yield of 3.36%. So, just to be conservative, a reasonable FCF yield would be at least 4.5%.
That implies that IBM could eventually have a market value of around $266.7 billion. This can be seen by dividing $12 billion in forecast FCF by 4.5% (i.e., $12b/0.045 = $266.7b).
In other words, IBM stock is at least 45% undervalued since $266.7 billion is 45% higher than its existing $183.86 billion market cap. That sets its price target at $289.32 per share.
So, no wonder there is a large volume of out-of-the-money (OTM) call options in IBM stock today.
Unusual Call Options Volume Today
This can be seen in the Barchart Unusual Stock Options Activity Report on Aug. 28. It shows that over 5,000 call options contracts have traded at the $210 strike price for expiration on Nov. 15, 2024. That is over two and a half months from today (79 days).
Moreover, these IBM call options have a strike price that is $10 or so over today's price. That means it is 5% out-of-the-money (OTM).
The price of these calls is $4.78, so the breakeven price is at least $214.78 (i.e., $210+$4.78). After that, the calls start to have intrinsic value. That implies that investors must expect IBM stock will rise over 7.6% in the next 2.5 months.
But this may be worthwhile since IBM is at least 45% undervalued and potentially worth over $289 per share. As time goes on these call options buyers expect IBM stock will move closer to that price target.
Moreover, call options buyers may just be willing to flip the call options. For example, let's say in the next month IBM stock rises to $215 (up 7.5%). The price of the calls is likely to be at least $5.00 per share (i.e., $215-$210 strike price) and likely much higher due to extrinsic value. It could easily trade for $10 or more. That implies the investors could double their money over the next 2 months.
Shorting Calls Also Is Bullish on IBM
The sellers of these call options also see this trade as a bargain. For example, the bid side is $4.65 per call. That represents a covered call yield of 2.33% (i.e., $4.65/$199.53). Moreover, if IBM stock rises to $210 and the shares are called (i.e., sold) the investment produces a capital gain of 5.25% (i.e., $210/$199.53).
So, the investor stands to make a total return of 7.58% (i.e., $214.65/$199.53 = 1.075778) over the next two months or so. That is essentially a bullish stance on the stock. The only risk is that IBM could rise even further.
One way to mitigate that is to use the income to buy further out-of-the-money call options. For example, the $225 calls cost $1.53 in the midprice. In other words, the net income would still be $4.65-$1.53, or $3.12, which represents a covered call yield of 1.56%. If the stock rises over $225 or even gets close to it, the covered call investor can capture a portion of that rise.
The bottom line is that this is a bullish way to play the expected rise in IBM stock over the next several months.
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.
