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Nvidia Inc. (NVDA) stock still looks undervalued after its pullback based on its strong free cash flow and FCF margins. This is good news for investors shorting out-of-the-money (OTM) puts for income and lower buy points.
To short an OTM put means entering an order to “Sell to Open” a put option at a strike price below the existing spot price. Although you keep the premium as immediate income, you must first secure the cash to buy the stock at this strike price with your brokerage firm.
This works best for stocks you are happy to own should the stock fall. In that case put option is exercised by the owner of the put.
For example, I described a short-sale put option play in NVDA stock in my last Barchart article on March 19: “Nvidia Stock Has More Upside If Its FCF Margins Stay High - Shareholders Can Short Puts for Income.”
I discussed shorting the $840 strike price put option set to expire on April 12. NVDA stock was at $885.70, so the strike price was 3.4% below the spot price and the expiration was 3 weeks away.
But here is why the trade looked interesting. The premium received by the short seller of this put option was $27.85 per contract. That means the short seller made an immediate 3.315% yield (i.e., $27.85/$440.00). On April 12, NVAD stock closed at $881.86, so the option expired worthless. The short-sale investor had no obligation to buy the stock at $840 and kept that yield.
So, now it makes sense to do this trade again. But first, let's review why NVDA still looks undervalued here.
Nvidia's Powerful FCF and Margins Lead to Higher Target Price
During the last fiscal quarter ending Jan. 31, Nvidia made an astounding free cash flow (FCF) margin of 51%. This means it made $11.217 billion in FCF on quarterly revenue of $22.103 billion.
I discussed the implications of this at length in my Feb. 28 GuruFocus article, “Nvidia's Huge FCF Margins Imply It's Worth More.” This is a direct result of selling A-I-related semiconductor products that are hugely popular with many software companies now.
Based on analysts' estimates, Nvidia could achieve between $111.45 billion and $136.14 billion in revenue in the next 12 months (i.e., $123.8 billion on average). If the company keeps generating 50% FCF margins going forward, it's possible free cash flow could reach $61.9 billion. Even using a lower 45% margin implies that FCF in the next 12 months could rise to $55.87 billion.
As a result, the market is likely to give the stock at least a 2% FCF yield valuation. That implies that its market cap will rise from $2.17 trillion now to $2.79 trillion, or up 28.7% from here. This is seen by dividing $55.87 billion by 0.02. The net result is that NVDA stock could be worth at least 28.7% more, or $1,139.90 per share.
Shorting OTM Puts for Income and a Buy Entry Point
As discussed above it makes sense to to sell short cash-secured OTM put options in nearby expiry periods. That way existing shareholders can gain extra income and those who haven't bought yet can set a disciplined, target buy-in price.
For example, look at the May 3 expiration period, less than 3 weeks from now. It shows that the $850 strike price, 3.6% below the April 12 price of $881.86, trades for $20.80 on the bid side.
This means that the short put investor can make an immediate 2.45% put yield (i.e., $20.80/$850) in a cash-secured put trade. Here is what that means.
The investor must first secure $85,000 in cash and/or margin with their brokerage firm. This secures the situation if the NVDA falls to $850 and the investor is obligated to buy 100 shares at that price. Then, after gaining approval to do this kind of option trade, the investor can enter an order to “Sell to Open” 1 put contract at $850 for expiry on May 3.
The account will then immediately receive $2,080 (i.e., 100 x $20.80) per contract shorted. That works out to an immediate yield of 2.447%. The investor hopes that the stock won't fall to $850. But even if it does hit $850, their breakeven price is $20.80 lower or $829.20 per share (i.e., 6% below today's price).
That means that it is ideal for existing investors who are already long NVDA stock. But it also works for others who may be looking to buy in at a lower price but want to set that price now. They get to keep the income, but take the risk that they never get to buy the stock if NVDA doesn't drop from here. Therefore, it makes sense to keep doing this trade every 2 or three weeks, especially before the next earnings release comes out.
The bottom line is that Nvidia still looks undervalued here. A cheap way to buy in and make extra income is to short OTM puts in nearby expiry 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.
