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Broadcom (AVGO), the semiconductor and software firm, makes huge free cash flow profits. That's why AVGO stock is popular with investors. As a result, shorting OTM puts now is a good income play.
In fact, recently AVGO stock has been rising as it is now at $885.23, up from $829.08 on Sept. 22. Investors have recognized that the stock was too cheap after the company's recent earnings announcement on Aug. 31.
I described this situation in my Sept. 24 Barchart article, “Broadcom Looks Deeply Undervalued Given Its Massive Free Cash Flow Margins.”
High FCF Margins Lead to Higher Target Price
The main point that I made was that the company's recent fiscal Q3 52% free cash flow (FCF) margins were extraordinary. For example, FCF for the quarter ending Aug. 31 was $4.587 billion on revenue of $8.876 billion.
That means that over half of its sales went straight into its bank account with no cash obligations, making it “free” to be spent on dividends, buybacks, acquisitions, etc.
As a result, we can estimate the stock's target value using these high FCF margins.
Here's How. Let's assume a 50% FCF margin and apply analysts' $38.74 billion revenue estimates for the year ending Oct. 2024, That means FCF could reach $19.37 billion for the fiscal Oct. 2024 year.
We can use that FCF estimate to imply a price target. For example, using a 5% FCF yield (the same as multiplying FCF by 20x), Broadcom's market cap could reach $387 billion.
Today Broadcom's market cap is about $362.7 billion. That implies the stock could rise by 6.8%.
Moreover, using a 4% FCF yield (i.e., 25x FCF), its market cap could rise to $484 billion. That implies an upside of 33.5%. So, on average the stock's target valuation could be about 20% higher.
That puts the target price at $1,062 per share, up 20% from today's price of $885.23.
Shorting OTM Puts for Extra Income
Last month we recommended selling short the Oct. 13 expiration put options for the $785 and $790 strike prices. Those ended up profitable plays as the stock closed at $883.13. The investors who did this trade kept the $7.80 and $8.60 put income, or yields of 0.99% and 1.088% respectively.
Today, near-term expiration puts also have attractive premiums. For example, the $835 and $840 strike prices for the Nov. 10 expiration period put options have attractive premiums. They are at $11.05 and $12.20 respectively.
That means that the investors can make an immediate yield of 1.32% and 1.45% respectively. This is seen by dividing the premium of $11.05 by the $835 strike price (i.e., 1.32%), and dividing $12.20 by $840 (i.e., 1.45%).
Here is what this means on a practical basis. The investor can make money by securing $83,500 in cash and/or margin with their brokerage firm. Then they can enter an order to “Sell to Open” 1 put contract at the $835 strike price for expiration on Nov. 10.
The account will then immediately receive $1,105 in cash. That works out to 1.32% of the $83,500 invested. If this trade can be repeated every month for a year, the investor stands to make an expected return of $13,260, or 15.88% of the $83.5K invested to make this return.
Moreover, the strike price is 5.42% out-of-the-money (OTM), meaning that it is 5.42% below today's spot price. That provides downside protection to the short-put investor.
The bottom line is that investors can make money shorting OTM puts while they wait for AVGO stock to rise at least 20% to its target price based on its abundant free cash flow.
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.
