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Trading in Microsoft Corp (MSFT) call options that expire in 2.7 years at a deep in-the-money (ITM) strike price highlights the underlying value of MSFT stock. Using call options like this can be a cheaper way to buy the stock on a long-term basis.
The call options trade shows up in the Barchart Unusual Stock Options Activity report today. The trade shows that 7,000 call options at the $380 strike price for MSFT expiring on Dec. 18, 2026, were traded. The price was $115 on the ask side of the trade.
That means that some large investor(s) felt it was easier to pay $115 and hold the call options in MSFT stock rather than buy 700,000 shares at $426.62 per share. If the stock rises to over $495 (i.e., $380+$115) sometime in the next 988 days (i.e., 2.7 years) it will make sense to exercise those call options.
So, in effect, the investor is willing to pay $495 in the long run for MSFT stock, putting $115 as a downpayment now. That represents a 16% premium over today's price. But, they must feel that in the long run, this is a more profitable way to buy MSFT shares. Let's look at why that might make sense.
Microsoft's Long Term Outlook
Analysts surveyed by Seeking Alpha forecast that revenue will rise by over 15.3% from $211 billion last year ending June 30 to $244.3 billion this FY. Moreover, next year ending June 2025, they see sales reaching $279.3 billion, a gain of over 31.8% from this past year.
This is being powered by the company's intense focus on AI products. The CEO, Satya Nadella, told investors in his recent Jan. 30 earnings conference call, “We have moved from talking about AI to applying AI at scale.”
As a result, the company's free cash flow (FCF) is set to rise significantly over the next several years. This is despite higher planned capex spending by Microsoft for data centers to benefit from its focus on AI products.
In the trailing 12 months (TTM) it generated $67.4 billion in FCF on $227.4 billion in TTM sales. That works out to an FCF margin of almost 30% (29.6%). Going forward this implies that by June 2025, if its margins stay that high, the company could generate up to or over $80 billion in FCF.
This implies that MSFT stock could be worth significantly more than its existing market value. For example, using a 2.2% FCF yield, implies its market cap could rise to $3.636 trillion. And with a 2.0% FCF yield metric, its valuation could rise to $4 trillion (i.e., $80b/0.02 = $4,000 b).
How to Play This
This is 25.9% higher than its existing $3.175 trillion market cap. In other words, the stock could rise almost 26% from here to over $520 per share. Analysts surveyed by Refinitiv, as seen on Yahoo! Finance's summary page have an average $460.92 price target. But the highest target price is $550 per share.
Similarly, AnaChart, a new sell-side analyst recommendation tracking service, shows that the average of 39 analysts' target prices is $470.12 per share. This shows that many analysts forecast a much higher price for the stock.
As a result, it makes sense for a large investor like this to buy long-term calls, sometimes called LEAPs, to cheaply buy the upside in the stock. For example, let's say that the stock reaches $530 in the next year. That means that the in-the-money (ITM) call price will rise to at least $150 per call contract on an intrinsic basis (i.e., $530-$380 strike price).
That represents a gain of 30.4% over the next year in the investor's ROI, vs. a stock price gain of 26% or so. However, the benefit to the large investors is that they did not have to lay out as much cash to buy this upside. The 7,000 calls would cost $805,000, vs. a cost of $298.8 million for 700,000 MSFT shares.
That shows that it makes for long-term investors in MSFT stock to buy these deep-in-the-money long-period expiration call options to gain a leverage effect on the upside.
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.
