Microsoft (MSFT) stock still looks attractive to value investors given its massive free cash flow and reasonably cheap metrics. Moreover, short sellers of near-term put options are making good money. This is despite the recent dip in MSFT stock. In fact, it actually looks like a good buying opportunity here.
As of early trading on Sept. 1, 2023, MSFT stock is up over $2.00 to $329.53. During August it fell $8.16 from $335.92 at the end of July to $327.76, or just 2.43%.
So, far this quarter, since the end of June, MSFT is off about $11.00 from $340.54 or 3.2%. However, year-to-date, MSFT stock is actually up 37.4% from $239.82. at the end of 2022.
Microsoft's Huge FCF Margins
In my July 31 on Microsoft in Barchart I discussed the company's massive free cash flow (FCF) and how that could affect the stock's upside. The article, “Cheap Stock Alert: Microsoft and Its Huge Free Cash Flow - Options Plays Look Attractive,” pointed out that its FCF margin had risen dramatically.
For example, in its fiscal Q4 ending June 30, Microsoft's FCF margin hit 37.4%. This is the result of its $21 billion in quarterly adj. FCF and dividing it by the quarterly revenue of $56.1 billion.
That means that over 37% of every dollar of revenue goes straight to its balance sheet. This cash flow is unencumbered even after capex spending, working capital needs, and all its cash expenses. As a result, the FCF is then “free” to be spent on dividends, buybacks, acquisitions, etc.
Moreover, Microsoft has one of the highest FCF margins (37.4%) in the tech stock space. For example, Alphabet (GOOG) generated just 31.25% FCF margins in Q2 (i.e., $21.778 billion / $69.685 billion in revenue).
In fact, even Apple (AAPL) made just 29.7% FCF margins in its latest quarterly earnings ending July 1. I explained this in my recent Aug. 6, 2023, article, “Apple Stock Tumbles After Earnings, But Its Free Cash Flow Growth Makes It a Buy.”
As a result, investors are paying close attention to Microsoft's valuation.
MSFT Stock Still Looks Attractive Here
In my July 31 Barchart article on MSFT stock, I showed that it's reasonable to expect Microsoft could make $100 billion in free cash flow for the year ending June 30, 2024.
Therefore, using a 3.0% FCF yield, Microsoft stock could hit a $3.33 trillion valuation (i.e., $100b/3.0% = $3,333 billion). That represents a gain of 36.6% over its $2.44 trillion market capitalization today.
In other words, MSFT stock could be worth as much as $450 per share (i.e., 36.6% over today's price of $329.53). There is no guarantee that it could hit this valuation.
In fact, just to be conservative we could use a 3.5% FCF yield. That implies that its $100 billion in FCF could produce a market cap of $2.857 billion, or 17% over today's price. That works out to a price target of $385.55 per share.
This still makes MSFT stock attractive to value investors over the next year. In addition, traders can make extra income by shorting out-of-the-money (OTM) put options.
Shorting OTM Puts
For example, with the expiration period ending Sept. 29, 28 days from today, the $310 strike price puts look attractive. The premium at that strike price, which is 5.78% below the spot price (i.e., out-of-the-money) is $1.63 per put contract.
That means traders who sell short these puts make a good income of 0.526% for one month. That works out to an annualized return of 6.30%. So, if the investor already owns MSFT stock they can enhance the stock's meager 0.82% annual dividend yield.
Here is how that works out. First, a trader secures $31,000 in cash and/or margin with their brokerage firm. Then they can enter an order to “Sell to Open” 1 put contract at the $310 strike price for expiration on Sept. 29. The account will then immediately receive $163.00 per put contract shorted.
That $163 works out to 0.526% of the $31,000 invested for one put contract that was sold short. So, if it is repeated each month for a year, the holder could make $1,956 in additional income (assuming the exact trade and yield can be repeated). That $1,956 return divided by the $31,000 invested is an ROI of 6.30%.
Of course, there is no guarantee that trade can be repeated. But it shows the general rate of return available by shorting OTM puts in MSFT stock. Moreover, even if the stock falls below $310, the investor buys more shares at this lower price, potentially lowering their average buy-in cost.Moreover, the trader can then sell short OTM calls with the shares. That could help reduce any potential unrealized loss from the exercise of the put options.
The bottom line is that this is a good way to play the potential upside in MSFT stock. This works especially well for MSFT shareholders who want to enhance their dividend yield in this extremely profitable company.
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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.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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