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Microsoft Corp (MSFT) stock is still undervalued based on its free cash flow upside in the next year. MSFT stock could be worth 39% more or $518 per share based on $96 billion in FCF estimates next year. This is also based on a potential 2.5% FCF yield valuation.
I show how this works out in this article below. I also show a cheap way for existing shareholders to play this for extra income by shorting out-of-the-money (OTM) put options.
I already discussed this in my prior Barchart article on Nov. 14, but now I am updating this projection. Since then, MSFT stock has risen to $374.23 as of Friday, Dec. 8.
FCF Estimates Close to $100 Billion In the Next 12 Months
My target price is based on its free cash flow (FCF) and where it could rise in the next 12 months (NTM). For example, it made $20.7 billion in FCF in its latest quarter ending Sept. 30, according to page 5 of its shareholder deck. That was up 22% YoY.
More importantly, this represented 36.6% of the total revenue of $56.5 billion for the quarter. That 37% FCF margin implies that if sales reach $243 billion this fiscal year (ending June 30, based on analysts' estimates for 2024) free cash flow could rise to $90 billion. That is seen by multiplying $243 billion by 0.37.
And for the year ending June 2025, analysts forecast $276.75 billion, FCF could rise to $102.4 billion. That implies that the average FCF estimate over the NTM is $96.2 billion.
That is close to $100 billion in FCF projections sometime in the next 2 years. How will the market value this?
MSFT Stock Could Be Worth $518 Per Share
Here is how I think the market will value MSFT stock. In the last 12 months (LTM) Microsoft has generated $95.967 billion in cash flow from operations (CFFO). After deducting $31.741 billion in capex spending, its LTM FCF was $63.226 billion. These figures can be seen in Seeking Alpha's cash flow statements page for the LTM ending Sept. 30.
Now since Microsoft presently has a market capitalization of $2,773 billion, that means that the market values the company with a 2.28% FCF metric. This is seen by dividing its $63.2 billion by its market cap (i.e., $63.22b / $2,773b = 0.0228).
So, we can use that FCF yield metric to value its NTM FCF, i.e., $96.2 billion. For example, if we use a more conservative FCF yield of 2.5% we get a market value estimate of $3,848 billion (i.e., $96.2b/.025 = $3,848 billion).
That market value estimate is 38.8% over today's market cap of $2,773 billion. In other words, MSFT stock is worth 39% more. That puts its price target at $518 per share (i.e., 1.39 x $374.23 per share).
So how can existing shareholders play this?
Shorting OTM Puts for Extra Income
One way for investors in MSFT stock to make money while they wait for the stock to hit this price target is to sell short out-of-the-money (OTM) put options. It's best to focus on puts that expire in near-term expiration periods like the Dec. 29 period, for example. That is just 3 weeks away.
For example, the $357.50 strike price put trades for $1.95 on the bid side. That play is 3% out-of-the-money (i.e., below today's price) and yields 0.545% (i.e., $1.95 / $357.50).
A more conservative play is the $350 strike price which trades for 99 cents. That is 5% OTM and yields 0.282% to the short seller of these puts.
In any case, the annualized returns for both are still attractive. For example, the $357.50 strike price put yield works out to an annualized expected return (ER) of 9.27% (i.e., 0.545% x 17). This assumes the same trade can be repeated 17 times a year. Obviously, that won't always happen, but the ER calculation highlights the potential return at this rate.
The $350 strike price put yield works out to an annualized ER of 4.80% (i.e., 0.283% x 17). This has less of a chance of ever getting exercised since the strike price is 5% below today's price. But even if that happens the investor's obligation is simply to buy 100 MSFT shares at $350 per share. That would be done by the $35,000 that the investor has to secure with the brokerage firm at the time of entering the order to “Sell to Open” 1 put contract at $350 per share for expiration on Dec. 29.
The bottom line is the MSFT is worth almost 40% more. Existing investors can get paid by shorting OTM strike prices in near-term expiration periods.
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.
