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Based on recent bad news, Alphabet Inc (GOOGL) stock is trading below its 3-month lows. However, the company is still generating huge amounts of free cash flow and should keep doing this. That makes GOOGL stock worth over 29% more at over $193 per share.
GOOGL is at $149.47 in midday trading on Tuesday, Sept. 10. This is below its 3-month low point, but well off its recent peak of $191.18 on July 18.
Recent bad news is the likely culprit. The U.S. government is opened its second anti-trust trial on Monday against the company based on its ad technology software. And an EU court upheld a potentially huge tax penalty case that could cost Alphabet billions.
Nevertheless, Alphabet is still likely to keep generating large amounts of free cash flow in the near to medium term. That is what the market is overlooking.
Free Cash Flow Should Remain Strong
For example, last quarter Alphabet reported on July 23 that its revenue rose 15% on a constant currency basis to $84.74 billion and its free cash flow (FCF) remained strong at $13.54 billion.
That means its FCF margin was 16% ($13.54b/$84.74 billion). Moreover, over the last 12 months (LTM) its FCF margin was 18.5%, based on $60.787 billion LTM in FCF and $328.28b in LTM sales. I pointed this out in my July 26 Barchart article after the company released its Q2 results.
As a result, since analysts forecast that next year's revenue will rise over 11% to $386.54 billion, its free cash flow could reach $71.5 billion (i.e., 0.185 x $386.54b). That represents a rise of 17.6% over its LTM FCF of $60.787 billion.
It also implies that the stock could be worth significantly more.
Target Price for GOOGL Stock
For example, if we assume that the market will value GOOGL stock with a 2.5% FCF yield, its value could be $2,860 billion (i.e., $2.86 trillion). That is over 55% more than its present market cap of $1.84 trillion.
However, just to be conservative, let's use a 3.0% FCF yield metric. That is the same as multiplying the FCF estimate in 2025 by a multiple of 33.3x (i.e, the inverse of 3.0% is 33.33). So, this puts its forecast market cap at $2,381 billion (i.e., 33.33 x $71.5 billion est. FCF in 2025). That is still 29.4% over today's market cap of $1,840 billion.
In other words, GOOGL stock is worth at least 29.4% more, or $193 per share (i.e., 1.294 x $149.47 today).
Analysts who cover the stock agree that it's undervalued. For example, Barchart's survey shows a mean target price of $204.00 per share, and Yahoo! Finance's survey of 47 analysts has an average of $202.66.
In addition, AnaChart's analysis of 43 analysts who've recently written on the stock has an average price target of $173.90. That is still over 16% higher than today's price. The bottom line is that analysts everywhere see the stock as too cheap now.
One way to play this is to sell short out-of-the-money (OTM) put options. That sets a lower price target to buy in and also generates income while the investor waits for this to happen.
Shorting OTM Puts
For example, the Oct. 4 expiration period, a little over three weeks from today, shows that the $135 strike price put option, almost 10% below today's price, has a bid-side premium of 70 cents. That represents an immediate yield of 0.52% for the short seller over the next 3 weeks.
This means that the investor who secures $13,500 in cash and/or margin per put contract will make an immediate $70 for every put contract shorted. That could turn into $280 over the next four times that the investor repeats this trade, assuming the yield stays the same. In other words, expected return (ER) is over 2.0% (i.e., $280/$13,500) in the next quarter, by shorting near-term OTM puts.
The downside is that GOOGL stock could fall further than $135.00 per share in the next three weeks. At that point, the investor could end up with a short-term unrealized capital loss. But at least the investor's risk is limited to buying the shares.
In that case, the investor can continue to hold the shares, repeat more OTM short put or call plays, and/or wait until GOOGL stock rises to its underlying value. Moreover, the breakeven price is actually lower at $135.00-$0.70, or $134.30. That is over 10% below today's spot price, so this is a good buy-in price compared to its value.
The bottom line is that GOOGL stock looks cheap here, despite recent bad news. That is based on its strong free cash flow, its FCF margins, analysts' higher revenue forecasts, and analysts' target prices that are well over today's price.
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.
