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Despite its recent rise, Alphabet Inc. (GOOG) stock could still be undervalued. Analysts have been raising their price targets ahead of earnings at the end of the month. Shorting out-of-the-money puts can yield 1% over the next 3 weeks.
GOOG is at $167.27, up substantially from a recent low about a month ago. It hit a trough of $149.54 on Sept. 9.
On Sept. 10, I wrote in Barchart that GOOG stock was cheap: “Alphabet Stock Is Down, But Not Out - GOOGL Could Be Worth 29% More.” I argued that GOOG was worth at least $193 per share based on its strong free cash flow (FCF) and FCF margins.
Moreover, I showed that shorting out-of-the-money (OTM) puts was one way to play this. This play also works today. First, let's look at the price targets.
Price Target Update
Here is an update. Analysts project revenue will reach $386.99 billion next year. Using an 18.5% FCF margin, which is its last 12-month (LTM) FCF margin, Alphabet could generate $71.593 billion in 2025.
That implies that its valuation could be substantially higher. For example, using a 3.0% FCF yield metric, its historical valuation, the stock could end up with a market cap of $2.386 trillion (i.e., $71.593b/0.03 = $2,386 billion).
That represents a potential 16.3% rise in GOOG's market value of $2.052 trillion today. So, GOOG stock is worth $194.53 per share (i.e., 1.163 x $167.27 today).
That is close to what other analysts have as their price targets. For example, AnaChart reports that 43 analysts have an average price target of $193.57. In fact, these same analysts upgraded their prior average of $173.90 as I noted in my prior article.
The bottom line is that GOOG stock still looks cheap here. One way to play this is to both own the stock and also short out-of-the-money puts.
Shorting OTM Puts
For example, look at the Nov. 8 put option expiry chain - a little over three weeks from today (24 days). It shows that the $155.00 strike price, which is over 7.4% below today's trading price, has a price of $1.74 in the midprice.
That represents an immediate short-put play yield of 1.12% (i.e., $1.74/155.00).
That means that an investor who secures $15,500 in cash or buying power with their brokerage firm can enter a trade to “Sell to Open” 1 put contract at $155.00 for expiry on Nov. 8. The account will then immediately receive $174 if the midprice is obtained.
So, as long as GOOG stays over $155.00 for the next 24 days, the account will not be assigned to buy 100 shares at $155.00. Moreover, even if that happens, the investor's breakeven price is $155.00-$1.74, or $153.26. That is 8.37% below today's trading price.
In other words, it provides a good yield - 1.1% for the next 3 weeks - with over 8.3% downside protection. That makes it ideal for existing shareholders to do this trade. That way they gain all the potential upside in GOOG stock as well as additional income. The worst that can happen is that they buy more shares.
One interesting point to note here is that the delta is about 20% - which is ideal for shorting OTM puts. That implies that for every $1.00 move in the underlying stock, the put will move 20 cents. In other words, if the stock falls $10, the put will rise by $2.00. But in this case, the option is over $12 out-of-the-money (OTM), so there is still a good chance of making money.
The bottom line is GOOG stock looks cheap here. One way to play this is to both own GOOG shares and short OTM puts in nearby expiry periods.
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.
