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Sell-side stock analysts continue to raise their price targets on Microsoft Corp (MSFT) stock. One way to play this is to sell short out-of-the-money (OTM) MSFT puts. They provide a short-put yield of over 1.3% one month out for a 4% lower strike price.
MSFT is trading at $492.50, just off its recent peak of $497.45 on June 26. It could have much further to go, based on our free cash flow (FCF) based price target and analysts' recent recommendations.
My June 10 Barchart article ("Microsoft Stock is Up In the Last Month - Is MSFT Still a Buy? ") showed how MSFT could be worth $581.71 per share. That is still 18% over today's price, but at the time it was almost 24% than the price at the time of the article ($469.69).
Upgrading our Price Target
This price target was based on Microsoft's strong free cash flow (FCF) and FCF margins. However, there is reason to upgrade our price target, as analysts have done.
For example, using a 29% FCF margin (the same as its latest quarter) and analysts' next 12-month (NTM) revenue average of $298 million, we forecast $86.42 billion in FCF.
Then, using a 2.0% FCF yield (i.e., the same as a 50x FCF multiple), we forecast a market cap of over $4.32 trillion:
$86.42b FCF x 50 = $4,321b market cap.
However, it now makes sense to look one full year out to the fiscal year ending June 30, 2026, using revenue forecasts for the period. For example, Seeking Alpha shows that 57 analysts now project FY 2026 revenue (for the year ending June 30, 2026) will be $316.49 billion.
That means our new FCF estimate, using a 29% FCF margin, is higher at almost $92 billion for FY 2026:
29% x $316.49 billion = $91.78 billion FCF
That raises our market cap estimate, using a 2.0% FCF yield (i.e., a 50x multiple):
50 x $91.78 billion = $4,589 billion (i.e., almost $4.6 trillion) market cap
Today's market cap, according to Yahoo! Finance, is $3,655 billion. As a result, MSFT's value could rise by +25.6% from here over the next year:
$4,589 b/ $3,655b = 1.2555 -1 = +25.55%
That means MSFT stock is worth 25.55% more, or $618 per share:
$492.50 x 1.2555 = $618.09 new price target
That is +6.2% from my prior price target.
Analysts Raised Their Target Prices
Moreover, since then, analysts have significantly raised their price targets. For example, Yahoo! Finance now shows that 60 analysts now have a $522.26 average price target. That is up from $512.04 as of June 10.
In addition, Barchart's average survey price target is $522.81, up from $515.74 on June 10. So, on average, analysts have raised their price targets about +1.65% in the last 3 weeks.
Moreover, AnaChart.com, which tracks recent analysts' stock price recommendations, shows that 37 analysts have an average price target of $556.11. That is +4.78% higher than the June 10 price target average of $530.74.
This shows that analysts agree with my FCF-based analysis: MSFT is still deeply undervalued.
However, there is no guarantee this will occur. The stock could fall from its peak. One way to play this is to set a lower buy-in target by shorting out-of-the-money (OTM) put options. This also provides existing shareholders with extra income.
Shorting OTM MSFT Puts
In my last Barchart article, I suggested selling short the $450 strike price put option that expires on July 18. This was slightly over 4% below the trading price of $469.36. The investor received $4.10 in midpoint premium, representing a yield of almost 1% (i.e., $4.10 / $450.00 = 0.00911 = 0.91%.
However, now those puts have fallen in price to just 53 cents at the midpoint. So, most of the $4.10 premium has already been earned by the short-seller. It might make sense for a trader to cover this trade (i.e., enter an order to “Buy to Close”), and roll it over into a new short-put trade.
For example, the Aug. 8 MSFT put expiration period shows that the $470.00 strike put has a premium of $6.80 per put option contract shorted. That is slightly over 4% below today's price.
So, the short-put yield is higher than before (for new investors), almost 1.5%:
$6.80/$470 = 0.01447 = 1.447% (38 days to expiry)
Moreover, for investors who rollover the prior trade, the new yield is still high:
$(6.80 - $-0.53)/$470.00 = $6.27 / $470 = 0.1334 = 1.334%
The point is that this is even higher than the original short-put yield, even though MSFT stock has risen. So, in total, the rollover trade provides a total yield of 1.334% and 0.91%, or 2.244% over the period from June 10 to July 18 (i.e., 38 days).
In addition, less risk-averse investors can short the $475.00 put for $8.05, for a net gross yield of 1.69% (i.e., $8.05/$475.00), and a net (post-rollover) yield of 1.583% (i.e., $7.52/$475.00). That is just over the next 38 days, so the annualized expected return is very high.
The result of these plays is that investors using a mix of these trades to make a 1.5% short-put yield over the next month.
Moreover, the breakeven point is lower for an investor buying into MSFT if the account is assigned to buy at $470. For example, the breakeven buy-in point (if MSFT falls to $470 over the next month) is:
$470 - $6.80 = $463.20, or 6.16% below today's price
That provides huge upside, over one-third higher, given our $618.09 price target:
$618.09/$463.20 = 1.334 = +33.4% upside
The bottom line is that MSFT looks very cheap here. Our new FCF-based price target, as well as analysts' upgrades, shows it is at least 20% to 25% undervalued.
So, it makes sense for new investors in MSFT to set a lower buy-in price target by shorting OTM puts. Existing shareholders can make extra income shorting these OTM puts as well.
