Cheap Stock Alert: Microsoft and Its Huge Free Cash Flow - Options Plays Look Attractive

Microsoft (MSFT) reported massive free cash flow (FCF) growth on July 25 for its fiscal Q4 ending June 30. At $19.8 billion FCF was up 12% YoY, but after deducting a one-time tax payment, it was up 19% to $21 billion. 

As a result, MSFT stock is now considered cheap by analysts who can project an even higher FCF next year. In fact, traders now find options plays such as long-call buys and short sales of out-of-the-money puts are attractive.

Free Cash Flow Projections and Target Price

For example, based on the adjusted $21 billion FCF Q4 figure, it is apparent that Microsoft made an extremely high 37.4% FCF margin, as its Q4 revenue was $56.1 billion. We can use that to project FCF for next year.

For example, 43 analysts surveyed by Seeking Alpha forecast $266.7 billion in revenue next fiscal year to June 30, 2024. That means that if we apply the $37.4% FCF margin, all things else being equal, Microsoft could generate $100 billion in FCF.

That figure allows us to estimate a price target. Here is how. First, note that $100 billion is approximately 4.0% of its $2.51 trillion market cap. Historically, however, large-cap stocks like this with huge free cash flow can have peak valuations with 3.0% to 3.33% FCF yields.

For example, if we divide $100 billion by 3.0%, the resulting market cap target is $3.33 trillion, up 32.8% over today's $2.51 trillion market value. At 3.33% the market cap target is $3.0 trillion, up 19.6% from today's market cap.

In other words, MSFT stock, trading at $336.95 in early trading on Monday, July 31, is worth between 20% to 33% more, or between $404 to $449 per share. Let's call it $427 per share, or 27% over today's price. We can use that to set a target price for options plays.

Long-Term Call Plays

Given this high target price, it makes sense to look at buying long-term call options, perhaps 4 months in the future. For example, take the Nov. 17, 2023, options expiration period, which is 111 days from now.

The $380 strike price calls, which are 12.3% over today's spot price, trade for $6.70. The $385 strike price, 13.8% higher, is at $5.78 per call contract. 

After paying for the calls, an investor has to hope that MSFT stock rises to either $386.70 (up 14.8% from today), or $390.78 (up 16.0% higher).

The call buyer may not mind paying for these calls since their target price is well over $400 per share for MSFT stock. For example, assuming it rises to $400 per share, the $380 call premium will be worth at least $20 (i.e., $400-$380), plus an extra amount of extrinsic value since there is time left in the call option period. The $385 call option would be worth at least $15.00.

That means the call buy would make at least 200% (i.e., $20/$6.70-1), and the $385 strike price call buyer would make 160% (i.e., $15/$5.78-1).

Moreover, it's possible that the trader could have some of the call option price paid for by shorting near-term out-of-the-money (OTM) puts.

Shorting OTM Puts for Income

Another to make money on MSFT stock is to short OTM puts in near-term expiration periods - in fact, repeating the bets. This income can be used to pay for long-term call purchases. 

For example, the Aug. 18 put expiration period shows that the $325 strike price, 4% below today's spot price, trades at $2.72 per put contract. That provides an immediate yield of 0.83% (i.e., $2.72/$325).

Moreover, if this trade can be repeated just 3 times - i.e., over the next 9 weeks, or about half of the expiration period of the long-call purchase period, it can be used to pay for the calls. This can be seen by multiplying the $2.72 per call contract premium received by 3x, or $8.16. This is greater than the $6.70 call purchase at $380, with $1.46 left over.

The risk with this play is if MSFT falls below $325 on or before Aug. 18. In that case, the investor will have the $32,500 that was secured with the brokerage firm in cash and/or margin to purchase 100 shares of MSFT stock at $325.00. 

But the investor still keeps the income generated from the short-put play. And, as we have noted, it could have already been used to buy the long-term call options. Moreover, the investor can then also sell short covered calls to help pay for any unrealized loss that they may have.

Therefore, given our analysis, there is a good likelihood that MSFT will be worth well over $400 per share over the next year. Our analysis shows that there are good ways to make money in MSFT stock. This can be done by buying long-term calls and shorting near-term OTM puts.

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