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Alphabet Inc. (GOOG) stock has been treading water for the past month. This is despite clear indications that GOOG stock is undervalued based on its strong free cash flow (FCF). This is ideal for existing investors to create income by shorting out-of-the-money puts.
GOOG closed at $167.43 per share on Friday, Aug., about flat with the price on July 26 of $168.68, a month ago. It is only slightly lower since releasing its Q2 results on July 23 (closing the next day at $174.37).
This article will show how you can take advantage of this lull, especially if you are already a shareholder in GOOG stock. The idea is to sell short out-of-the-money (OTM) put options in nearby expiry periods.
In essence, you can make extra income without fear of having to sell your shares if GOOG stock rises (as covered call plays can lead to).
Why Alphabet's FCF Should Stay Strong
There is good reason to believe Alphabet's FCF will be strong over the next year. That could lead to a higher stock price. I discussed this in my July 26 Barchart article, “Alphabet Shows Lower Free Cash Flow Based on AI Spending - But GOOG Stock Could Still Be Cheap.”
For example, Alphabet posted 14% higher revenue last quarter, and its operating income margin stayed high at 32% vs. 29% a year ago.
However, the company's free cash flow (FCF) was lower than both last year and last quarter. This was due to higher capex spending on its AI initiatives. Alphabet hopes these investments from its existing earnings and cash flow will pay off in the long run.
Nevertheless, the market may have overdone its concerns about this lower FCF performance. For example, Alphabet said its capex spending will be lower going forward, reaching about $48 billion over the next year.
As I pointed out in my last article, analysts now expect sales to rise 11.3% next year to $386.64 billion. Given that its operating cash flow margin came in at 31.5% last quarter, this implies that Alphabet could potentially generate $121.79 in operating cash flow if these margins hold up.
Therefore, deducting $48 billion in capex spending from this results in a forecast of $73.79 billion in FCF going next year. That could help push the stock higher. Here's how.
Target Price for GOOG Stock
One way to use this FCF forecast to set a value for GOOG stock is to use an FCF yield metric. This could lead to a 20% higher stock price, using this FCF yield metric.
For example, in the last 12 months (LTM) Alphabet has generated about $60.787 billion in FCF. Its market value today is $2,049 billion (i.e., $2.05 trillion). That means the market is valuing Alphabet stock with a 3.0% FCF yield (i.e., $60.8b/$2,059b = 0.0297 = 3.0%).
Therefore, if dividing the 2025 FCF forecast of $73.79 billion by 3.0% the result is a $2,460 billion market value estimate. That is 20% higher than today's $2,049 billion market value. In other words, GOOG stock could be worth $200.92 (i.e., 1.20 x $167.43) per share sometime in the next year.
Keep in mind this assumes that analysts' revenue forecasts are achieved (or at least the market believes they will be), the operating cash flow margin stays at 31.5% over the next year and capex spending stabilizes at $48 billion.
Analysts Agree
Analysts tend to agree that Alphabet stock is undervalued. For example, Yahoo! Finance reports that the average price target of 12 analysts for GOOG stock is $180.42. Barchart's mean survey result is $203.76 per share, similar to my estimate.
In addition, AnaChart, a new tracking site that reviews sell-side analysts' price targets, reports that the average of 10 analysts is $184.65. That is over 10% higher, and two analysts, who have written recently on the stock, have price targets well over $200. That can be seen in the AnaChart table below.
It shows that both analysts have recently raised their price targets and project between 27% and 33% upside in the stock.
Note that they have very good track records. For example, the Oppenheimer analyst, Jason Helfstein, has been right 96.88% of the time when he sets his price targets on GOOG stock (i.e. 31 out of 32 price targets. Similarly, the Cowen analyst has been right almost 96% of the time.
That should give investors a very good indication that GOOG stock could likely rise over the next year. One way to play this is to sell short out-of-the-money (OTM) put options in nearby expiry periods.
Shorting OTM Puts for Income
For example, look at the Sept 27 expiration period, a little over a month from now. It shows that the $155 strike price put option expiring 9/27/24 trades for $1.09 on the bid side. That provides an immediate income of 70.3 basis points (i.e., $1.09/$155.00 = 0.00703 = 0.703%) to the short seller of these puts.
Here is what this means. Let's say you already own some shares in GOOG stock. That may give your account some margin ability. But your brokerage firm will require you to secure at least $15,500 in unclaimed cash or a mix of cash and margin equal to that amount to do this trade. That is because you have to guarantee that your account can buy 100 shares at $155.00 (i.e., 100 x $155 = $15,500) since every option contract represents 100 shares.
Next, you need approval from your brokerage account to be able to do this kind of trade. After that, you can enter an order to “Sell to Open” 1 put option contract at $155 for expiration on Sept. 27.
Then, immediately, your account will receive $109. That is because 100 shares (per put contract) x $1.09 = $109. If you short 5 contracts, your account has to secure $77,500 (i.e., 5 x $15,500), and then the account will receive $545. In both cases, your immediate yield if 0.703%.
Downside Risks
Keep in mind that you can repeat this trade if the stock does not fall over 7.4% over the next month. So, for example, the expected return (ER) for a quarter is 2.1% (i.e., $327/$15,500), if the same option price is available for this kind of trade every month.
Moreover, some investors may be willing to take on more risk. The $160.00 strike price put above has a premium of $1.73. That means you can make $173 by securing $16,000 and then shorting this put. But note that this is only slightly over 4.4% out-of-the-money.
If GOOG stock falls to $155 or $160 your account will be required to buy 100 shares of GOOG stock. But note that your breakeven price will be lower since the short-put income is already in the account.
The bottom line is that this is a way for existing investors to make extra income. Given that GOOG stock has a very low dividend yield (0.48% annually), this is a way to get paid while waiting for GOOG stock to rise.
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.
