Microsoft Corp (NASDAQ:MSFT) has demonstrated robust revenue growth and impressive free cash flow (FCF) margins in its latest Q4 results. Analysts project that based on FCF forecasts, MSFT stock could potentially be undervalued by up to 25%, potentially reaching over $500 per share. This presents an enticing opportunity for investors, particularly short sellers of out-of-the-money (OTM) put options, as a means to generate income.
The previous short-put option play proved successful, with the option expiring worthless. Investors were able to pocket the income generated, amounting to $2.47 (equivalent to a 0.63% put yield), without any obligation to purchase the stock at the predetermined strike price. This capital can now be reinvested into another short-put play.
Setting Price Targets Using Free Cash Flow Estimates
When engaging in short-put option strategies, it’s crucial to ensure that the underlying stock is substantially undervalued to provide momentum for potential price appreciation. One method involves setting a price target based on FCF and FCF margins. Analyst estimates suggest that Microsoft could generate approximately $83.7 billion in FCF over the next 12 months, based on a 32% FCF margin and revenue projections.
Using a 2.25% FCF yield metric, equivalent to a market cap estimate of $3.72 trillion, suggests that MSFT stock could be valued at $500.55 per share, representing a 25% increase from its current market cap of $2.98 trillion. This valuation discrepancy provides an incentive for existing shareholders to engage in short-put strategies for additional income.
Shorting OTM MSFT Puts for Income
Examining the put option chain for the March 15 expiration, investors can consider selling OTM puts to generate income. For instance, the $390 strike price puts, trading at $4.05, offer an immediate income of 1.038% for the short seller. Alternatively, more conservative investors may opt for the $385 strike price puts, trading at $3.00, providing a 0.78% short put yield.
In the event of MSFT stock falling to the strike price, investors should be prepared to purchase shares at the predetermined price. However, with the underlying stock potentially undervalued, investors can take comfort in the belief that MSFT is worth substantially more.
Furthermore, investors can leverage the acquired shares from exercised short-put options in covered call option strategies to generate additional income, mitigating potential unrealized losses.
In conclusion, Microsoft stock presents an attractive opportunity for investors to engage in short-put strategies to generate income, leveraging the stock’s potential undervaluation and strong fundamentals.
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