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Palo Alto Networks (PANW), a company with huge free cash flow (FCF) margins, looks attractive to value investors. Moreover, its put options premiums are high, making them attractive to short sellers.
For example, investors can make a short-put yield of over 2.4% by shorting 8% out-of-the-money (OTM) strike prices expiring in just over three weeks. This article will describe this play.
PANW stock is at $363.43 in midday trading on Tuesday, Oct. 29. The stock could be worth significantly more. That makes shorting out-of-the-money (OTM) puts a good way to set a buy-in price.
Price Targets for PANW Stock
I discussed in a recent Barchart article that PANW is worth $448 per share ("Palo Alto Networks Is Gushing Huge Amounts of Free Cash Flow - PANW Stock Could Be Worth 20% More.")
For example, Palo Alto Networks reported on Aug. 19 that it made an adj. FCF margin of 38.9% for the year ending July 31. Based on analysts' estimates of $9.13 billion in revenue for the year ending July 25, its FCF could reach $3.47 billion this fiscal year, using a 38% FCF margin estimate.
So, assuming the market values the company with a 2.5% FCF yield, its market cap could rise to $138.8 billion (i.e., $3.47b/0.025). That is 17.3% higher than its $118.38 billion market cap today.
In other words, PANW stock could be worth at least $426.36 within one year. This assumes it makes a 38% FCF margin and the valuation is 40x FCF (i.e., the inverse of a 2.5% FCF yield).
Analysts tend to agree that PANW is undervalued. For example, Yahoo! Finance reports that the average analyst price target is $385.88. Barchart's survey is $387.39 and AnaChart's average is $386.50 from 35 analysts' price targets.
One way to play this is to set a lower buy-in price target and get paid for waiting for this to happen. That can be done by selling short out-of-the-money (OTM) puts.
Shorting OTM Puts
For example, look at the Nov. 22 expiration period, 24 days from now - a little over three weeks away. It shows that the $335.00 strike price put option, which is over 8% below today's trading price, has a bid price of $8.10.
That means that a short seller of these put options can make an immediate 2.418% yield.
Here is how to do this. The investor secures $33,500 in cash or buying power with their brokerage firm. Then they can enter an order to “Sell to Open” 1 put contract at $335.00 for expiration on Nov. 22.
The account will immediately receive $810.00. That represents over 2.418% of the $33,500 invested.
The point is that the investor has set an 8% lower buy-in price and immediately received a 2.4%+ yield over the next 3 weeks. The bottom line is that PANW stock looks cheap here and shorting OTM puts is a good way to set a buy-in price.
Note that the expiration period of Nov. 22 is close to when Palo Alto Networks is likely to report its next quarterly results. If the stock stays flat the put option could expire worthless.
But even if the stock price falls to $335.00 the investor's cash will be used to buy 100 shares. Given that the stock's target price is much higher this may work out to be a good buy-in price.
Moreover, at that point the investor could sell short more OTM puts or covered calls. Over the long term, this may work out to be a good investment.
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.
