Microsoft Stock Offers a Great Value Equation Here

Microsoft (MSFT) stock looks like a good value play here. Its good yield, low P/E, earnings growth, and large buybacks will equate to a higher price. Our analysis shows that it's worth at least $337.39, or 26% more than today at $267.70 as of June 24. One way to play this is to buy near-the-money calls several months out. This article will describe this play.

MSFT stock is down 20% year-to-date (YTD), but just flat in the past year. Based on analysts’ forecast and its powerful free cash flow (FCF), it could move substantially higher.

What MSFT Stock Is Worth

For the year to June 30, 2023, analysts project a 15% higher EPS at $10.70 per share. This puts MSFT stock on a forward multiple of 25.0 times. However, this is significantly lower than its five-year average of 28x according to Morningstar.

So, this implies that the stock is worth $300 per share (28 x $10.70). But if we look at its valuation from a free cash flow (FCF) standpoint it could be worth much more. Last quarter its FCF margin was over 40%. Even if we use a lower 37% margin and apply it to June 2023 revenue forecasts of $227 billion, we get a FCF estimate of $84 billion.

Using a 3% FCF yield metric, this works out to target market cap of $2.8 trillion (i.e., $80/0.03 = $2,800 billion). That is 40% over its market cap today of $2.4 trillion. This implies a price target of $374.78. 

So now we have two price targets: $300 (12% higher) based on average P/E multiples, and $374.78 (based on FCF estimates). That averages to about $338 ($337.39) per share between the two. We can use that to determine how play this with call option strike prices.

How To Play This with Call Options

Let's say it will take at least one quarter for the stock to start moving higher substantially towards this target price. If we look at the Sept. 16 call option chain, the near-the-money strike price of $270.00 costs $15.20 per call option:

This shows that the all-in cost to purchase 100 shares would be $285.20, if the call options were exercised. That leaves a potential profit of about $53 (i.e., $338 price target - $285 cost), or 18.6% if we held the calls to expiration and then exercise them..

However, we could make huge leveraged profits just trading the call options, assuming MSFT stock reaches this target price by expiration For example, our cost with the calls is $15.20, and the intrinsic value of the call options by expiration will be $68.00 per share (i.e., $338 target price - the $270 strike price). Therefore, our gain will be $52.80 on a cost of $15.20, or 383%.

In other words, we get almost 4 times leverage here using call options. Of course, there are all kinds of downside risks, especially if MSFT stock does not move up. However, since we have 84 days for this to work out, we can always extend, or roll over the 3 month-period to a later strike price chain (with some cost, obviously). 

This shows how we can make very good money on MSFT stock using directional call options based on its target value.

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