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Microsoft (MSFT) stock is still trading well below its real or true value, based on its powerful free cash flow. Today MSFT is at $331 or so on June 27, which is well below a target price of $379.54, which is over 15% higher. This is good for traders who short OTM puts as an income play and as a way to buy in automatically at a lower price.
In my June 9 Barchart article, “Microsoft Stock May Have Peaked, But It's Still On Track For Solid Growth,” I showed that for the year ending June 30, 2024, free cash flow (FCF) could rise to $84.9 billion. That FCF figure is derived by using a 36% FCF margin based on analysts' June 2024 fiscal year revenue expectations of $235.69 billion in revenue.
Using FCF to Set a Price Target
As a result, using a 33x multiple, MSFT stock would have a market capitalization of $2.8 trillion (i.e., $84.9b FCF x 33x). That is 14.8% over today's price. After adding another 0.74% due to share buybacks, its market capitalization could rise by 15.5% from yesterday's price of $328.61, or $379.54 per share.
In other words, based on expected FCF margins and revenue growth we can expect to see Microsoft's value per share rise 15.5% to $379.54 next year. Traders can use that price to short out-of-the-money put options.
That will both increase income from MSFT's low 0.83% dividend yield. It also provides a way to automatically buy in cheaper (if MSFT stock falls to the OTM strike price).
Shorting OTM Puts in MSFT Stock
For example, the July 21 put option chain shows that the $320 strike price put options trade for $3.05 per option. That works out to an attractive yield of almost 1.0% in just 24 days (i.e., ($3.05/$320)/100=0.95%). That means that if the trader can repeat this kind of trade each month for a year, the annualized return will be 11.4%, regardless of whether MSFT rises substantially to the target price.
Here is what this means from a practical standpoint. First, the trader secures $32,000 in cash and/or margin with their brokerage firm. Then they can enter an order online to “Sell to Open” one 1 put contract at the $320 strike price for July 21 expiration. The account will then immediately receive $305.00.
That is why the yield is considered 0.95% since $305/$32,000 is 0.95%. Assuming that MSFT stock does not fall 3.55% to $320 on or before the July 21 expiration date (and the trader does not buy back the short put position) the investor will have a clean 0.95% return. They will not be obligated to purchase the stock at $320 using the secured cash and/or margin.
Lowering Risk with Deeper OTM Short Puts
A more conservative trader may want to have more room for the stock to fall. For example, the $310 strike price is over $20 below today's price or 6.56% out-of-the-money. The premium is lower at $1.51 as well.
That represents an immediate yield of 0.49% or a little over half of the $320 strike price put trade. But at least there is significantly less risk that MSFT could fall to this strike price.
Moreover, the annualized return to the trader, if repeated each month for a year, is 5.88%. That is significantly higher than the stock's 0.86% dividend yield. So, in effect, without much risk that the stock could fall here, especially given the much higher price target we have shown above, the deep OTM short-put trader can gain a lot of extra income.
This also has an advantage over selling OTM covered calls, since there is no danger of the shares owned by the investor being sold in an exercise. The investor has already secured the money to purchase the stock, so in effect, it can be a way to automatically buy in MSFT stock at a lower price.
Granted, there could be an unrealized loss if the stock tanks. But I have shown that MSFT stock is worth at least 15%+ more than its price today, and that likelihood is low.
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.
