/Microsoft%20Logo%20on%20Building%20over%20Nordstrom%20Store.jpg)
Microsoft (MSFT) reports its Q4 results in two weeks. It could show strong free cash flow results just as it did in Q3. As a result, MSFT stock could be worth $519 per share, or 35% higher.
Given the stock's paltry 0.78% dividend yield, shareholders can gain extra income while they wait for this higher price by selling short put options. This works best with out-of-the-money (OTM) puts in near-term expiry periods.
I discussed these points in my last Barchart article, “Microsoft Could Be Worth Over $500 Per Share Based on Its Massive Free Cash Flow.” I showed how MSFT is worth $518 per share which is still 35% higher than yesterday's close of $384.63. Today the stock is higher at $385.69.
I also suggested that shorting the $357.50 strike price for expiration on Dec. 29 would be worth the $1.95 premium received. As it turned out, MSFT closed at $376.04 on Dec. 29, so the premium yield of 0.545% in just 18 days was kept without having to buy more MSFT shares. This trade can now be rolled over.
But first, let's review why MSFT stock is still so undervalued.
Why MSFT Stock Is Worth $518, 35% More
The main reason is the company's very high free cash flow (FCF) margins. For example, last quarter Microsoft generated $20.7 billion in FCF on $56.5 billion in revenue for the quarter. That works out to a 36.6% FCF margin.
Moreover, in the trailing 12 months (TTM) to Sept. 30 the company made $63.2 billion in FCF on $218.3 billion in revenue. That represents a 28.9% FCF margin. This shows that the Q3 FCF margin represents an acceleration in its powerful free cash flow performance.
If we apply that 37% Q3 margin to future revenue estimate we can project $96 billion in FCF in the next 12 months (NTM). Here is how that is done. Analysts project revenue of $243 billion for the year ending June 2024 and $277.3 billion for June 2024. That works out to an average of $260.15 billion. Applying a 37% margin to this yields an FCF estimate of $96.3 billion in free cash flow.
This will lead to a significantly higher stock price. Here is why. Microsoft's average FCF yield has been 2.5%, which is also equal to 40x FCF. This leads to a market cap target of $3,852 billion (i.e., $96.3b FCF est. x 40). That is 34.7% higher than its present $2,860 billion market cap.
In other words, MSFT is worth 35% more than yesterday's close of $384.63, or $518.10 per share.
Shorting OTM Puts for Extra Income
Shareholders can wait for this to happen over the next year while getting paid a $3.00 dividend. That works out to a yield of just 0.78%. But in the meantime, they may want to generate extra income. One way to do this is short out-of-the-money (OTM) puts while still owning MSFT stock.
For example, look at the Jan. 26 put option expiration period in two weeks. That coincides with the company's expected press release date of Jan. 25 for Q4 earnings.
It shows that the $375.00 strike price put options trade for $1.74 on the bid side. That means that the short seller of these puts can make 0.464% in immediate yield (i.e., $1.74/$375.00). The strike price offers 2.75% downside protection below today's stock price and roughly a 3.21% breakeven level (i.e., ($375-$1.74)/$385.62).
Here is how that works out on a practical basis. The shareholder in MSFT stock must get approval from their brokerage firm to do short put trades. One requirement is to secure the dollar amount needed to buy 100 shares should the stock fall to the strike price.
In this case that means securing $37.500 (i.e., 100 x $375.00 strike price in the put contract). That can be using cash and/or margin (especially since there is margin available from already owning MSFT shares if they are an existing shareholder in MSFT stock).
Next, the investor enters an order to “Sell to Open” 1 put contract at $375.00 for expiration on Jan. 26. The account will then immediately receive $174.00 (i.e. 100 x $1.74). That is why we say that the immediate put yield is 0.464% (i.e., $174 received by selling short/$37.500 invested).
Moreover, if this trade could be repeated every two weeks for a year, the annualized expected return (ER) would be $4,524/$37,500 or $12.06%. That is a very high yield in and of itself.
This shows that investors in MSFT stock can expect to see a much higher price. Shareholders can generate extra income, as high as 12% annually, by selling short OTM puts.
More Stock Market News from Barchart
- Markets Today: Stocks Recover Most of Overnight Losses on a Friendly U.S. Dec PPI Report
- S&P Futures Tick Lower Ahead of Key U.S. PPI Data and Big Bank Earnings
- 3 Stocks Ready to Rocket as the Market Rebounds (Hint: They Just Hit This Key Indicator)
- Stocks Settle Mixed as Bond Yields Fall Despite a Strong U.S. CPI Report
