PepsiCo (PEP) showed that its results for Q3 on Oct. 10 had a massive 36% gain in its free cash flow (FCF). As a result, value buyers are looking carefully at PEP stock. One major reason is it is trading below its historical price-to-earnings (P/E) and dividend yield metrics.
The company said its "organic" revenue growth (i.e., excluding currency and acquisitions/divestiture effects) was up 8.8% YoY. Management also said it expects to see a 10% YoY organic 2023 gain.
Huge Gain in FCF
However, more importantly, its FCF rose from $3.75 billion in the 9 months last year to $5.093 billion this year. That represents a massive 35.8% gain YoY in its free cash flow. What's more, most of that occurred during Q3.
For example, in the latest quarter, according to figures from Seeking Alpha, FCF rose from $3.368 billion in Q3 2022 to $4.587 billion in Q3 2023. That represents a huge 36.2% in FCF in the past year. If this keeps up, investors can expect to see a massive gain in the company's cash buildup. It is already up over $5 billion in the last year and now stands at just over $10 billion.
That could have a huge effect on the company's dividend-paying plans. For example, in July the company just raised its dividend by 10% YoY to $1.265 quarterly ($5.06 per annum).
PEP Stock Trading Below Historical Metrics
That gives PEP stock an attractive dividend yield at today's price (Oct. 13 $160.00) of 3.16%. This is much higher than its 5-year historical dividend yield of 2.75%, according to Morningstar.com. This is consistent with what Seeking Alpha says is the stock's 4-year historical yield. Their figure for the 5-year average is 1.76%, much lower than today.
And given the huge gain in FCF, analysts could easily expect to see another 10% dividend hike next year. That is how value investors will see the stock. For example, let's say that PepsiCo raises its dividend by 10% to $5.57 next July. That gives the stock today a forward or prospective dividend yield of 3.48%.
As a result, if PEP stock were to trade at its historical mean of 2.75%, the stock should rise to over $202 per share. That can be seen by dividing $5.57 by 0.275. Even if we use this year's dividend of $5.06 per share, the target price should be $184.
In other words, the stock is worth somewhere between $184 and $202, or $193 on average.
This also coincides with a target price based on its historical P/E averages. For example, analysts expect earnings per share next year will reach $8.14 per share. Based on its historical forward P/E multiple of 23.6x, according to Morningstar, that gives a target price of $192.10 per share.
So, based on both its yield and forward P/E metrics, PEP stock is worth about 20% more at $192.50 per share.
Shorting OTM Puts for Extra Income
This makes it attractive to sell out-of-the-money (OTM) put options to gain extra income. For example, the November 3 expiration period, 20 days from now, shows that the $150 strike price puts trade for 37 cents.
This strike price is over 6% below today's price of $160, so it provides good downside protection. It also means that the short seller of these puts can make an immediate yield of 0.313%.
Here is how that works out on a practical basis. The investor secures $15,000 in cash and/or margin with their brokerage firm. Some of their existing shares in PEP stock can add to that requirement.
Next, the investor can enter an order to “Sell to Open” 1 put contract at the $150 strike price for expiration on Nov. 3. The account will immediately receive $47.00. That works out to 0.31% of the $15K invested.
If this is repeated every three weeks for a year, the expected return will be 5.33%. This can be seen by multiplying $47 by 17 times since there are 17 periods of 3 weeks in a year. That produces an expected dollar return of $799. This also represents 5.33% of the $15,000 that will be invested during that period.
The bottom line is that PEP stock is at least 20% undervalued here. Value investors can hold on to their existing shares and collect the 3.16% yield waiting for PEP stock to rise 20% to its target value. They can also short OTM puts in order to potentially buy the stock cheaper and collect extra income in the process.
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.
