Microsoft (MSFT) stock still looks cheap here based on its strong free cash flow. Its put premiums are now high enough to be attractive to short sellers. Shorting out-of-the-money (OTM) puts with high premiums in nearby expiry periods is a way to gain extra income waiting for MSFT to rise.
I discussed this strategy in a previous Barchart article on Feb. 20, “Microsoft Stock Looks Cheap to Investors, Including Shorting OTM Puts for Income.” I provided an analysis of selling short the March 15 $385 and $390 strike price puts.
At the time this short-put play yielded 0.78% and 1.038% with the put premiums at $3.00 and $4.05 respectively. The stock closed at $416.22 on March 15. So, these puts closed out worthless and the short-put play was very successful.
Today, MSFT is well above those strike prices at $422.88. It makes sense to do this kind of short-put play again, especially for existing investors who already own MSFT stock. This is because the stock has a low dividend yield of just 0.70%.
But first, let's review why Microsoft stock looks undervalued here.
Microsoft's Strong Free Cash Flow and MSFT's Value
Microsoft produced very strong free cash flow (FCF) last quarter. This is despite having spent $75 billion on its acquisition of Activision Blizzard at the end of 2023.
Moreover, the company is now fully integrating artificial intelligence into its product lines. As a result, the company's FCF margins have been ranging from 28% to well over 33% in the past four quarters on a trailing twelve months (TTM) basis.
I discussed the company's FCF and its valuation in a recent Apri 10, 2024, GuruFocus article, “Microsoft's Free Cash Flow Could Push Its Value Significantly Higher.” In the article, I show how the company's FCF could rise to $70 billion this fiscal year (ending June 30) and $80 billion next fiscal year. You can read the short article to see my methodology in valuing MSFT based on its FCF.
As a result, using an FCF yield metric of 2.0% to value MSFT stock, it could be worth $3.5 billion to $4 trillion. As a result, MSFT's value is between $470 and $537 per share. That means the stock is worth about $504 per share on average, or about 20% over today's price.
This also means it makes sense for existing shareholders to sell short out-of-the-money puts for income.
Shorting OTM Puts in MSFT Stock
Look at the expiration period ending May 3, which is 3 weeks away. It shows that the $395 strike price, which has a large volume of contracts outstanding, is trading for $2.80, and the $400 strike price puts are at $3.60.
That means that the short seller of these puts can make an immediate yield of 0.7088% for the $395 strike price short-put play and 0.90% for the $400 strike price.
Moreover, if the investor can roll these trades over every 3 weeks for a quarter, the investor stands to make 2.83% and 3.60% respectively in just 90 days. That is considerably higher than they can make with the MSFT dividend yield. It also provides extra downside protection if they are also holding MSFT shares long.
The bottom line is that Microsoft looks cheap here and shorting OTM puts is a way to play this for extra income.
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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.