Broadcom Stock Could Be Too Cheap Ahead of Its Upcoming Earnings

Broadcom Inc (AVGO) stock could be too cheap here based on its strong free cash flow (FCF) generation. Broadcom is set to release earnings in just over 2 weeks. One way to play this is to short out-of-the-money (OTM) put options.

AVGO stock closed at $165.72 on Friday, Aug. 16, off $17.17 from its June 17 peak of $182.89, or -9.38%. This is after rising 21.6% from a recent low of $136.27 on Aug. 7. 

However, it could still be undervalued using a free cash flow (FCF) yield analysis. This article will discuss target prices for AVGO stock and how to play this by shorting OTM put options.

Free Cash Flow Should Stay Strong

After Broadcom released its Q1 earnings on June 12, I discussed how much Broadcom could be worth in a June 14 Barchart article: “Broadcom, an AI Chip Stock, Just Split Its Shares Like Nvidia and Looks Cheap.”

For example, Broadcom produced 43% higher revenue for the quarter ending May 5 at $12.487 billion. Analysts now project that sales this upcoming fiscal Q3, to be released on Sept. 5, will be 3.78% higher on a QoQ basis at $12.96 billion.

In fiscal Q2 Broadcom's adjusted free cash flow (FCF), not including VMware restructuring and integration charges, was $5.3 billion. That represents an FCF margin of 42.44%, which was in line with the trailing 12-month (TTM) non-adjusted FCF margin of 43.15% (i.e., $18.39 b/$42.619b revenue).

Moreover, management projected that its fiscal year revenue ending Oct. 2024 will be $51 billion. Analysts project $51.5 billion this year and $60.11 billion next year.

In other words, if its FCF margins stay strong at 42%, Broadcom could produce as much as $25.25 billion in free cash flow (i.e., 0.42 x $60.11b).

Target Prices for AVGO Stock

That has huge implications for the upside in AVGO stock. Let's assume the market values the company's FCF using a 2.5% yield metric. For example, its TTM FCF of $18.39 billion represents 2.38% of its existing $771.4 billion market capitalization.

Therefore, if we divide the 2025 project FCF of $25.25 billion by 2.5% the result is a projected market cap of $1,010 billion, or $1.01 trillion. That represents a potential increase of 30.9% over today's market cap of $771.4 billion.

In other words, AVGO stock could be worth 30.9% more, or $216.93 per share (i.e., $165.72 x 1.309). However, just to be conservative, lowering the FCF estimate to $23.44 billion (i.e., a 39% FCF margin), results in a lower market cap estimate of $937.6 billion.

That brings in a more conservative target price 21.5% higher or $201.35 per share.

Analysts Agree that AVGO Stock is Cheap

Sell-side analysts have higher target prices for AVGO stock. For example, Yahoo! Finance shows that its survey of 31 analysts has an average price target of $177.24. That is almost 7% over today's price.

Similarly, Barchart's survey shows that the mean analyst target price is $190.51. That is closer to my price target and represents a potential upside of 15% in AVGO stock. 

AnaChart.com, a sell-side analyst tracking site, shows that some of the top analysts have price targets ranging from $155 to $215.00 per share.

One way to play this, especially for existing investors is to sell short out-of-the-money (OTM) put options. That way they investor can generate extra income while they wait for AVGO to rise to these higher target prices.

Shorting OTM Puts

For example, look at the Sept. 6 expiration period, which is right after the Sept. 5 earnings release, and three weeks from today. It shows that deep OTM puts still have yields.

One attractive example is the $150 strike price put option. Its premium is $2.20, which provides a 1.467% yield over the next 3 weeks to the short seller. This can be seen by dividing the $2.20 bid side premium by the $150 strike price.

AVGO puts expiring Sept. 6 - Barchart - As of Aug. 16, 2024

Here is how that works. The investor secures $15,000 with their brokerage firm. Then, after receiving options trading approval to sell short puts, they can enter an order to “Sell to Open” 1 put contract at $150 for expiry on Sept. 6. The account will immediately receive $220, or 1.467% of the $15,000 invested.

That means if AVGO stock stays over $150 per share for the next 3 weeks, the investor gets to keep this income and any potential upside in AVGO stock. Moreover, they can repeat the trade every 3 weeks. 

For example, in one quarter, if the stock stays flat, it's possible over the next quarter the investor can make an expected return (ER) of $880 on $15K invested, or 5.87%. So, the investor has a good chance of making a good return here, especially since the breakeven price is $147.80 (i.e., $150-$2.20) per share, or 10.8% below today's price.

More conservative investors can short the $145 strike price for $1.40, or a yield of almost 1.0% (i.e., $1.40/$145.00). The tradeoff here is that the downside risk is much lower since the breakeven price is $143.60 (i.e., $145-$1.40), or 13.3% below today's price. 

No matter what strike price is chosen, there is a very good chance that AVGO stock will be worth much more over the next year. So, the short--put investor can keep repeating this trade every 3 or 4 weeks, as long as AVGO stays undervalued.

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.