Mastercard (MA) stock still has a 30% potential upside after its 17% climb from its Oct. lows. This is based on its massive free cash flow (FCF) margins. Shareholders can short OTM puts for extra income.
I described the company's powerful FCF and FCF margins in my Nov. 21 Barchart article, “Mastercard Is Still Worth 35% More Based on Its Massive Free Cash Flow.” At the time, MA stock on Nov. 21, MA stock was at $407.71 per share. On Friday, Dec. 22, it closed at $424.10 per share.
FCF Could Push MA Stock Higher
I pointed out that the company's Q3 report showed that its FCF margin for Q3 was 45.9%. That is based on its generation of about $3 billion in FCF on Q3 sales of $5.533 billion.
In other words, if Mastercard keeps this up, it might be able to generate $12.88 billion in FCF next year. That comes from multiplying 45.9% times analysts' forecasts of $28.09 billion in sales next year.
One way to value MA stock is to use an FCF yield metric. This uses the stock's assumed dividend yield today as a metric to value MA stock.
For example, Mastercard's dividend yield is fairly low at just 0.62%. But if it were to pay out the full amount of its FCF as a dividend the present dividend yield would be 3.0%. This is seen by taking the $3 billion in quarterly cash flow and multiplying it by 4, or $12 billion.
Given that its present market capitalization is $397.7 billion, the assumed 100% dividend payout yield would be $12b/$397.7b, or 3.0%.
Therefore, if we divide our forecast of $12.88 billion in 2024 FCF by 3.0%, the potential market cap will be $429.3 billion. But with this large payout its likely that the dividend yield would rise to at least 2.5%. So dividing $12.88 billion by 2.5% produces a target market cap of $515 billion.
That is 29.5% higher than today's market cap. This produces a target price of $549 per share (i.e., 1.295 x $424.10 = $549.21 per share).
Shorting OTM Puts Produces Extra Income
One way existing shareholders in MA stock can make extra income, given the stock's low dividend yield, is to sell short out-of-the-money (OTM) put options. This works best in near term expiry periods, such as the Jan 12, 2024, expiration (see below).
For example, look at the $410 strike price puts, which are 3.3% below (or out-of-the-money) Friday's spot price. The premium that a short seller of these puts will receive is $1.83 per contract. That works out to an immediate yield or income of 0.446% (i.e., about half of one percent) to the short seller.
Here is what that means on a practical basis. First, the short seller must deposit $41,000 in cash and/or margin with their brokerage firm. Then they must get approval to sell short cash-secured puts from the brokerage firm. This amount of money is sufficient to buy 100 shares at $410, in case the short sale is exercised (i.e., if the stock falls 3.3% to $410 by Jan. 12, 2024).
After that is approved, they can enter an order to “Sell to Open” one put option contract at the $410 strike price. Then the account will immediately receive $183.00 (i.e., $1.83 x 100 shares, since every put contract represents 100 shares).
The $183 represents 0.446% of the $41,000 that was deposited or secured with the brokerage firm. That money won't be free until either the option expires, is exercised, or the short-seller enters an order to “Buy to Close” the short-sale trade.
Handling Downside Risks
Even if the stock falls to $410 on or before Jan. 12 and the option is exercised, the worst that will happen is that the $41K already deposited will be used to buy 100 shares of MA. That could result in an unrealized loss. But all is not lost.
For example, the owner of these new shares could wait until MA stock rises to the $549 target price we showed above. Or they could sell covered call options to gain more income and make up for some of the unrealized loss. Moreover, they could sell the shares at a loss and do another short-put trade just like this, except at a lower strike price.
If this trade is repeated 17 times a year (since there are 17 periods of 3 weeks annually), the expected return (ER) is 7.82%. That is the result of multiplying 0.46% by 17x. My best guess is that at least one-third of the time this may not work out. But even if ⅔rds of the time it does, the ER is still 5.2%. That is much higher than the stock's present 0.62% dividend yield.
The bottom line is the long-term value owner of MA stock can still expect to see it rise significantly from here. One way to get paid to wait for this is to sell short OTM puts in near-term expiration periods.
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.
