Microsoft Still Looks Cheap, Worth 26% More Based on its FCF - Good for Short Put Income Plays

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Microsoft Corp (MSFT) stock still looks cheap based on its huge AI focus and FCF margins. MSFT could be worth up to $529 per share, +26%. Existing shareholders can make extra income by shorting out-of-the-money (OTM) put options.

MSFT closed at $420.21 on Friday, May 17. That is up +5.3% from where it closed on April 25 ($399.04) when it released its fiscal Q3 earnings ending March 31.

I discussed Microsoft's value and shorting OTM puts in my April 26 Barchart article, “Microsoft Shows Massive FCF Growth Despite High AI Spending - MSFT Looks Undervalued.” I also published a detailed analysis in my April 10 GuruFocus article.

In short, you can value MSFT stock using analysts' revenue forecasts and the company's most recent free cash flow margins. Let's look at this.

Valuing MSFT Stock Based on Its FCF

Microsoft reported that during its nine-month fiscal period ending March 31, it generated $50.75 billion in FCF. This can be seen by deducting $30.6 billion in capex spending from its operating cash flow of $81.353 billion during that period. That huge amount of FCF represents 28.1% of its $180.395 billion in revenue for the fiscal 9 months.

That is a massive FCF margin, which few companies can match. Moreover, Microsoft consistently produces these high margins. So going forward it's useful to project future FCF.

For example, analysts now project that next year ending June 30, 2025, revenue could reach $280.1 billion. This is slightly higher than prior forecasts and represents a 14.3% rise over revenue forecasts for the year ending June 30, 2024 ($245 billion).

Therefore, applying the 28.1% FCF margin ratio to the June 2025 revenue forecast results in an FCF forecast of $78.7 billion (i.e., $280.1b x 0.281). This can lead to a price target for MSFT stock. This is because MSFT's value can be seen as a function of FCF's forecast. The market cares deeply about how much FCF the company will generate, as it implies how much it could pay shareholders in dividends and buybacks.

Price Targets

For example, let's assume that the company pays out 100% of this FCF in dividends. Its market valuation is likely to end up with a 2.0% dividend yield. So, dividing $78.7 by 2.0% results in a market cap forecast of $3,935 billion, or $3.94 trillion.

That represents an upside of 26% over Microsoft's $3.126 billion market cap today. In other words, MSFT stock could be worth up to 26% more than its price today of $420.21, or $529.46 per share

Other analysts agree with this upside. For example, Barchart's survey of 36 analysts has an average price target of $470.26. That is 11.9% higher than today's price. Yahoo! Finance, using Refinitiv data, shows that 48 analysts have an average price target of $472.91 per share. And AnaChart, a new sell-side analyst recommendation tracking service, shows a similar average, of $472.65 for 39 analysts' price targets. AnaChart reports that currently out of the existing stock ratings of MSFT, 265 are a BUY (94.98%).

As a result, MSFT still looks undervalued here. One way to play this, especially for existing shareholders, is to sell short out-of-the-money (OTM) put options for extra income.

Shorting OTM Puts for Income

In my last Barchart article three weeks ago, I suggested shorting the $400 strike price put option expiring May 17 for a premium of $5.20. That represented a huge yield of 1.30% (i.e., $5.20/$400) to short sellers. 

Since MSFT closed at $420.21, the puts expired worthless, and the short seller not only kept all the income but also had no obligation to buy more shares at $400. That is why this type of play works best for existing shareholders since they also made the upside in the stock by shorting the OTM puts.

This play is possible again, although it is not as profitable. For example, look at the June 21 expiration expiry period, a little over a month from now. It shows that the $400 strike price puts are at $1.99 and the $405 strike price puts trade for $2.80 on the bid side.

MSFT puts expiring June 21 - Barchart - As of May 17, 2024

That implies that short sellers of these puts can make an immediate yield of 0.50% (i.e., $1.99/$400) and 0.69% (i.e., $2.80/$405.00) over the next month. Those represent good yields, although not extraordinary income returns. 

Nevertheless, it also represents extra income that existing shareholders can make. Even if MSFT stock falls to $405 or $400, existing shareholders, knowing the stock's price targets, won't mind buying more shares.

The bottom line is that shorting OTM puts like these is a good way to play MSFT as an undervalued stock.

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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.