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Nvidia (NVDA) stock keeps rising, frustrating its detractors who say it is overvalued. In early trading on Tuesday, Sept. 5 after the Labor Day weekend, NVDA stock is at $484.80. Meanwhile, short sellers of its out-of-the-money (OTM) put options have been making out and this play still looks profitable.
A week ago we pointed out this strategy in our Aug. 27 Barchart article, “Short Sellers of Nvidia Put Options Are Making Huge Profits.” At the time NVDA stock was at $460.18 per share and we wrote that the stock was undervalued (more on that below).
Profitable Trade Shorting OTM Puts
We also suggested shorting its $435 strike price puts that expire on Sept. 22. At the time they were trading for $11.03 per put and the strike price was 5.47% below the spot price (i.e., out-of-the-money).
Today, those puts are trading for just $2.57, down almost 77%. This is obviously because NVDA stock has risen over $24 since then. Moreover, the investor who did this trade has reaped most of the profit from that trade. In fact, if they were also long NVDA stock, they would have made money on the upside as well as from the OTM short-put strategy.
In fact, it probably makes sense to roll this trade over and short a closer OTM strike price. But first, let's review why NVDA stock still might be undervalued.
Nvidia's Huge Free Cash Flow and Margins
One reason that NVDA stock might be considered reasonable here is that Nvidia is generating huge amounts of free cash flow (FCF). Last quarter it made $6.048 billion in FCF for the quarter ending July 30. That was 2.89x the $2.643 billion in FCF made in the prior quarter ending April 30. And it was up significantly from the $824 million a year ago.
Moreover, compared to its revenue of $13.507 billion for the July 30 quarter, that implies that its FCF margin was an astounding 44.8% (i.e., $6 billion/$13.5 billion). That is one of the highest FCF margins in the whole tech world.
For example, Palo Alto Networks (PANW) reported huge free cash margins but they were at 38.7%. I discussed this in my recent Barchart article, “Palo Alto Networks Stock Is a Major Bargain, Especially for Short Sellers of Its Puts.”
Another comparison is Microsoft (MSFT). Their recent FCF margin was 37.4%. I described this in my recent Barchart article, “Microsoft Stock's Dip Looks Like a Good Opportunity to Value Investors.”
In other words, Nvidia's FCF margin is head and shoulders the highest large-cap tech company's FCF margins. This means it deserves a high valuation. In terms of FCF that means that its FCF yield should be low - in the order of 1% to 2%.
Target Market Cap and Upside
So, for example, if we divide its projected FCF (after applying its 45% FCF margin to estimates of revenue going forward) by 1% or 2% we can see if the stock is undervalued. So, for example, 43 analysts surveyed by Seeking Alpha now project sales this year of $54.08 billion for the year ending Jan. 2024 and $75 billion for Jan. 2025.
That means that FCF could reach between $24.3 billion and $33.75 billion (i.e., 45% x $54b, 45% x $75 billion). That means that its average FCF could reach $29 billion in the next 12 months.
So, if we divide this figure by 2% (i.e., $29b/0.02) the expected market capitalization could be $1.45 trillion. That is $250 million more than its present $1.2 trillion market cap, or an upside of 20.8%. And if the stock reaches a 1.5% FCF yield, the market cap could be $1.93 trillion, or +61%.
In other words, NVDA stock is worth between $581.76 (+20%) and $780.53 per share. This makes shorting OTM puts right now very worthwhile, especially while also owning shares in NVDA stock.
Shorting OTM Puts
As I suggested earlier, the Sept. 22 expiration put option chain period offers good opportunities for short sellers. For example, the $470 strike price puts, which are 3% out-of-the-money (OTM) trade for $11.48.
That means that the investor makes an immediate yield of 2.44% (i.e., $11.48/$470) with just 2 weeks until expiration. That works out to an annualized return of over 63%.
Moreover, the Sept. 29 expiration period shows that the $470 strike price puts trade for $13.08 per put. That works to an immediate yield of 2.78%, an annualized return of 47.3%
The bottom line is that NVDA stock is still worth significantly more than its price today. So, it makes sense to own the shares as well as short OTM puts for additional income.
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.
