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Nvidia Corp's (NVDA) free cash flow margins are very high and this could push NVDA much higher. While waiting for this, it makes sense to short out-of-the-money puts here based on their high premiums.
I discussed this situation and how the company's valuation could rise in my last Barchart article on Sept. 5, “Shorting Nvidia Puts Still Makes Sense as NVDA Stock Defies Naysayers.” At the time, NVDA stock was at $485.00 per share and today (Nov. 6) it's trading at $456.86.
Free Cash Flow Could Power NVDA Stock Higher
However, in the article, I argued that NVDA stock could be worth between $581.26 to $780.53 per share based on its powerful free cash flow (FCF). That means on average its price target will be $680.90 per share.
For example, Nvidia generated over $6 billion in FCF in its latest quarter ending July 31. That represented an astounding 44.8% FCF margin based on its quarterly $13.5 billion in revenue.
Moreover, in the upcoming quarter, Nvidia is forecast to generate up to $16 billion in revenue. That could raise its FCF to about $7.17 billion. This has huge implications for NVDA stock's valuation going forward.
For example, analysts now project revenue will rise to $54.08 billion this year ending Jan. 31 and $79.39 billion next year. That means over the next 12 months revenue could average $66.7 billion.
Therefore, using a 45% average FCF margin, implies that free cash flow could rise to $30 billion. This could push NVDA stock much higher.
For example, at a 2.0% FCF yield (the same as multiplying FCF by 50x), the market cap could be $1.5 trillion. That is 35% higher than Nvidia's present $1.11 trillion market cap.
In other words, NVDA stock could rise to $616.76, or 35% higher than its price today of $456.86 per share.
Shorting OTM Puts Here Makes Sense
While waiting for this to happen it makes sense to take advantage of the high put option premiums by selling them short. This creates extra income for investors who already own NVDA stock.
There is no risk here that the stock could be called away. The only risk is that the stock falls and you might have to buy more of the shares, possibly creating an unrealized loss. But it could also lower your overall dollar cost in the stock.
For example, look at the expiration period ending Nov. 24. This is 3 days after the company will report earnings on Nov. 21 for its quarter ending Oct. 30. This is also less than 3 weeks from today, but the put option premiums are very high.
Here is why. Look at the $430 strike price, which is over 5% below today's price (i.e., is well out-of-the-money - OTM puts). The bid price is $12.40, which represents a 2.88% yield on the $430 strike price for short sellers.
That is a very high yield for just 18 days until expiration. For example, if this can be repeated every 3 weeks, the annualized expected return (i.e., repeated 17x over the next 12 months) is 49%! That shows that this is worth shorting today.
Here is what this means exactly. An investor secures $43,000 in cash and/or margin with their brokerage firm. Then they enter an order to “Sell to Open” 1 put contract at the $430 strike price for expiration on Nov. 24.
Then immediately the account will receive $1,240. This is equal to multiplying the bid price of $12.40 by 100. The account gets to keep that amount whether or not NVDA stock stays above $430 per share or not by Nov. 24. But even if the stock falls to $430, the investor has a breakeven price of $417.60 (i.e., $430-$12.40), or 8.5% below today's price.
That means that if the investor can repeat this trade every 3 weeks for a year, the account will accumulate $21,080. That represents 49% of the $43,000 invested in this play over the year.
Moreover, if the investor is also holding NVDA stock they might be able to benefit from any upside in the stock, based on the price target we discussed above.
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.
