Amazon Stock is Still Very Undervalued and Shorting OTM Puts Makes Sense Here

Amazon Inc. (AMZN) reported strong free cash flow FCF margins last quarter. That implies that AMZN stock could be worth between 18% and 58% more. For existing shareholders, it makes sense to hold on and short OTM puts for extra income.

I discussed this strategy in my Feb. 12 Barchart article, “Shorting AMZN Puts Makes Sense Here for Existing Shareholders, Given its High Put Premiums.” At the time AMZN stock was at $173.46 and I recommended selling short the $167.50 put option expiring March 1 for $1.26 in premium. That put option expired worthless and the trade was successful as the investor made an additional 0.75% in income (i.e., $1.26/$167.50) in just 3 weeks.

Today, March 8, AMZN stock is slightly higher at $178.49, but it could be worth substantially more. So, it makes sense to do this short-put trade again. But first, let's review our price target for AMZN stock.

AMZN Stock Price Targets

My prior article's thesis was this. Amazon reported on Feb. 1 that its Q4 free cash flow for the last months represented 6.40% of sales (i.e., $36.8b FCF/$574.8). That FCF margin was one of its highest in the past year. 

Moreover, we can use that to forecast FCF going forward and then set a price target.

For example, analysts estimate that sales in 2024 will rise to $641.5 billion, up 18.4% from 2023. That means if its FCF margin stays at 6.40%, free cash flow will rise to $41 billion (i.e., 0.068 x $641.5b). That represents a potential gain of 11.4% from the $36.8 billion it generated in FCF during 2023.

Moreover, analysts now estimate that sales in 2025 will rise to $715 billion. So sometime in the next 12 months (NTM) the sales run rate will be $678.25 billion. Therefore, the FCF run rate for the NTM is $43.4 billion (i.e., 6.4% x $678.25b).

That is useful for setting a price target. For example, using a 1.5% FCF yield (i.e., assuming that 100% of FCF is used to pay a dividend), Amazon would end up with a $2,893 billion market cap. That is seen by dividing $43.4 billion by 0.015. This is 57% over today's market cap of $1,842 at $178.49 per share.

However, to be conservative, let's use a 2.0% FCF yield. That implies that the potential valuation in the NTM is $2.17 trillion. That represents an upside of 17.8% over today's $1.842 trillion market cap.

So, the bottom line is that AMZN stock could be worth between $210 per share (up 17.8%), and $281.65 (up 57.8%). As a result, it makes sense for shareholders to hold on. They can also make extra income by shorting out-of-the-money (OTM) put options in nearby expiry periods.

Shorting OTM Puts for Income

For example, look at the March 28 expiration period, which is 3 weeks away. It shows that the $165 strike price put, which is 6.40% below today's spot price, (i.e., 6.40% out-of-the-money), trades for 57 cents.

That means that any shareholder or investor who secures $16,500 in cash and/or margin with their brokerage firm can enter an order to “Sell to Open” 1 put contract at $165 for March 28 expiration. The account will then immediately receive $57. Therefore, the investment yields 0.345% (i.e., $57/$16,500).

As long as AMZN stock stays over $165 per share between now and March 28, the investor will have no obligation to use the $16,500 secured to buy 100 shares at $165. That would not be such a bad thing, anyway. We have shown that the stock is worth substantially more.

Moreover, if the investor can repeat this trade 4 times for the next quarter, the total expected return (ER) will be $228. That represents an ER of 1.38% for the next 90 days. That is more than many stocks pay out as a dividend yield over one year.

In addition, investors willing to take on more assignment risk can short the $170 strike price. That pays $1.23 per contract, or a yield of 0.72% (i.e., $1.23/$170). Over 90 days, the investor can make $492 or a total ER of 3% (i.e., $492/$16,500 = 2.98%).

The bottom line is that investors in AMZN stock can have confidence that the stock is worth substantially more based on its powerful free cash flow. They can make extra money by shorting OTM puts or as a way to buy into the stock more cheaply.

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.