Microsoft (NASDAQ:MSFT) is gearing up for its Q4 results in a fortnight, and optimism surrounds the anticipation of robust free cash flow, mirroring its impressive Q3 performance. If all goes well, MSFT stock might surge to $519 per share, marking a noteworthy 35% uptick.
With the current 0.78% dividend yield hardly making waves, investors can explore an alternative avenue for additional income by engaging in short put options, particularly those out-of-the-money (OTM) and with near-term expiry.
In a previous recommendation, shorting the $357.50 strike price for expiration on Dec. 29 proved lucrative, yielding a $1.95 premium without having to acquire more MSFT shares. The stock closed at $376.04 on Dec. 29, demonstrating a premium yield of 0.545% within just 18 days. This successful trade can now be rolled over for continued benefit.
Why MSFT Stock is Potentially Undervalued
The primary driver behind MSFT’s undervaluation lies in its exceptionally high free cash flow (FCF) margins. In the last quarter, Microsoft showcased a 36.6% FCF margin, generating $20.7 billion FCF on $56.5 billion in revenue. This performance represents an acceleration in its robust free cash flow.
Extrapolating the 37% Q3 margin to future revenue estimates points to a projected $96 billion in FCF in the next 12 months (NTM). Analysts foresee revenue hitting $243 billion for the year ending June 2024 and $277.3 billion for June 2024, averaging $260.15 billion. Applying a 37% margin yields an FCF estimate of $96.3 billion, potentially propelling the stock price significantly higher.
Anticipated Stock Price Surge
Considering Microsoft’s historical average FCF yield of 2.5%, equivalent to 40x FCF, a market cap target of $3,852 billion (i.e., $96.3b FCF est. x 40) emerges. This is a substantial 34.7% increase from its present $2,860 billion market cap. In essence, MSFT is deemed to be worth 35% more than its closing price of $384.63.
Generating Extra Income through Short Puts
While waiting for this surge, shareholders can opt for a $3.00 dividend, offering a modest 0.78% yield. Simultaneously, they can explore generating additional income by shorting OTM puts. Taking the Jan. 26 put option expiration, coinciding with the expected Q4 earnings release on Jan. 25, the $375.00 strike price put options trade at $1.74 on the bid side.
Selling short at this strike price allows the short seller to gain an immediate yield of 0.464% ($1.74/$375.00). The strike price provides a 2.75% downside protection below the current stock price, with a breakeven level of approximately 3.21% ($375-$1.74)/$385.62).
Investors keen on this strategy must secure $37,500 (100 x $375.00 strike price) to fulfill brokerage requirements. By “Selling to Open” 1 put the contract at $375.00 for expiration on Jan. 26, investors can receive $174.00 immediately. If repeated bi-weekly for a year, the annualized expected return (ER) could reach $12.06%, providing a high-yield option for MSFT stockholders.
Investors holding MSFT stock may witness a substantial price increase while concurrently generating extra income, potentially as high as 12% annually, through the strategic shorting of OTM puts.
Featured Image: Pixabay
