Domino's Pizza Stock Looks Cheap - Short Put Plays Work Here

Domino's Pizza (DPZ) stock may be undervalued based on its strong free cash flow (FCF) and upside in analysts' price targets. Short put plays one month from now have a 2.0% yield at a low out-of-the-money strike price.

DPZ stock closed at $347.85 on Monday, Aug. 10. That's 5.38% down from a recent peak of $367.64 (Aug. 4), but up from a recent trough on July 22 ($319.83). This was after it released strong results on July 20. But it could be worth much more.

I wrote about this in a July 21 Barchart article, just after it released results ("Domino's Pizza Delivers Strong FCF and FCF Margins - Is DPZ Stock Too Cheap?).

DPZ could be worth $417 per share (my price target), based on analysts' 2027 revenue forecasts ($5.31 billion), a 13% FCF margin (i.e., $690 million FCF), and a 5% FCF yield metric:

  $690.3m FCF /0.05 = $13.8 billion fair market value (FMV)

That's 20% over its present market cap of $11.5 billion (Yahoo! Finance), so the price target is 20% over today's price:

  $347.85 x 1.20 = $417.42 per share (price target)

Analysts have slightly lower price targets. Yahoo! Finance is at $386.74 (30 analysts), and Barchart's mean survey PT is $389.75.

That's why I suggested shorting out-of-the-money (OTM) puts to set a lower buy-in.

It worked out well and will do so again.

Shorting Puts Works with DPZ

I discussed shorting the $300.00 strike price put contract on July 21 (expiring a month later on Aug. 21) when DPZ was at $328.97 on July 21. That was just after the July 20 earnings release. 

The investor could earn a one-month yield of 1.42% since the premium received was $4.25 (i.e., $425/$30,000 invested). Today, the premium has dropped to just 20 cents, so it makes sense to close that out, just two weeks later.

Moreover, a new one-month put short-put play has a higher yield. For example, the Sept. 18 expiry put period shows that the $420 put has a midpoint premium of $6.80.

That means an investor who posts $32,000 in collateral can immediately earn $680 for the next month shorting this put. That works out to a 2.125% yield (i.e., $680/$32,000).

In effect, then, after closing out the other put at 20 cents, the total one-month income is:

  $425 - $20 + $680 = $1,085

The average invested capital over the period was $31,000. As a result, the net effect return on capital (ROC) is:

  $1,085 / $31,000 = 3.50% over 6 weeks

That works out to an annualized expected return (ER) of 30.345% (i.e., 8.67 periods of 6 weeks per year x 3.50%).

Downside Risks and Mitigation

Of course, this assumes the same yield can be repeated every 6 weeks by shorting out-of-the-money (OTM) DPZ puts.

But, at least that's better than buying and holding DPZ stock. The upside there is only 20% (based on my price target, as seen above).

And don't forget. Even if the put gets exercised, i.e., the $31,000 is assigned to buy 100 shares at $310.00, at least the investor has a much lower buy-in.

Of course, the downside is that DPZ could fall below the breakeven point. That's equal to:

  $310 - $10.85 in cumulative income, or $299.15. So, DPZ would have to drop over $47, or -14.0% from Monday's close. That provides very good downside protection.

Moreover, the investor can then sell covered calls to mitigate any unrealized loss.

The bottom line is that shorting DPZ put options here is a very attractive value-investing strategy.