Qualcomm Inc (QCOM) stock looks deeply undervalued here after its recent Q2 results which showed strong free cash flow margins. As a result, one attractive buy-in play is shorting out-of-the-money (OTM) QCOM put options.

QCOM stock is at $181.75 in midday trading on Friday, May 10. This is higher than its price before the May 1 release of its fiscal Q2 results when it closed at $164.11 per share. But, based on my estimates of its value, QCOM stock could be worth over $233 per share, or over 28% more in the coming year. 

This article will delve into that. Moreover, I will show that shorting OTM puts is a good way to set a disciplined buy-in target price as well as a way to gain extra income.

Qualcomm's Strong Free Cash Flow and FCF Margins

Qualcomm is a semiconductor designer that makes money selling its CMDA telecom handset licenses (the QCT division), as well as general technology licenses (QTL division) for uses in automotive and related fields. 

Both divisions have slow-growing revenue, up 1-2% last quarter on a year-over-year basis. However, its automotive Snapdragon chip sales, related to self-driving technology, were up 35% Y/Y.

More importantly, these two divisions, generate large profits. Earnings per share (EPS) was up 14% Y/Y. And due to low capex requirements, Qualcomm generates significant amounts of free cash flow (FCF). 

For example, in the last 6 months, the company's FCF was $6.1 billion, or 65% higher than last year's $3.7 billion FCF. Moreover, its FCF margins are very high. I discussed the company's significant FCF margins in a recent GuruFocus article: “Qualcomm is Undervalued.”

In the trailing 12 months (TTM) to March 24, Qualcomm's FCF represented 33.7% of its revenue. That was higher than the 31.56% YTD FCF margin and the fiscal year FCF margins of 27.5% for the year ending Sept. 30.

In other words, the company's cash generation is increasing. That should lead to a higher valuation for the stock.

Price Targets for QCOM Stock

One way to value this kind of stock is to use an FCF yield metric. This means dividing the projected FCF by a yield, such as 4% or 5%. That assumes that the market will give the stock a 4% or 5% dividend yield should the company pay out 100% of its FCF as a dividend.

For example, in this case, it makes sense to assume the market would give QCOM stock at least a 4.5% dividend yield. Analysts forecast revenue of $38.3 billion in revenue for the year ending Sept. 30, 2024, and $42.22 billion next year. That works out to a next 12-month (NTM) run rate of about $40 billion in sales.

So, using the 31.56% FCF margin it made in the past 6 months, this implies that FCF will be about $12.7 billion (i.e., 0.3156 x $40.26b). We can use that with the FCF yield metric to value QCOM stock.

For example, dividing $12.7 billion by 5% results in an expected market cap of $254 billion. That is 25.4% over its present $202.5 billion market cap. 

Moreover, using a 4.50% yield, which is the same as multiplying FCF by 22.2x, results in a $282.2 billion market cap, or +39.3%. The average of these two is a price target that is about one-third higher (+32.35%).

That means our price target is $240.54 per share, or 32.35% higher than today. 

Shorting OTM Puts to Set a Buy-In Target and Gain Extra Income

One way to play this is to short out-of-the-money (OTM). I discussed this in my last Barchart article on March 11. as well as my GuruFocus article this week.

For example, look at the June 7, 2024, put option expiration period, 28 days from now. It shows that the $170 strike price puts trade for $1.07 on the bid side. That strike price is over 6% below today's price and provides good downside protection as it is out-of-the-money (OTM).

It also provides an immediate income of 0.629% or almost 70 basis points to the short seller (i.e., $1.07/$170.00). If repeated over a quarter that has an expected return (ER) of 1.88%.

This means that anyone who secures $17,000 in cash and/or margin with their brokerage firm can enter an order to “Sell to Open” 1 put contract at $170 for expiration on June 7. The account will then immediately receive $107.00. That works out to a 0.629% yield on investment. Over 3 months, if repeated, this play could bring in $321, or almost 1.9%.

The bottom line is that is a good ER for any investor. Moreover, they would be willing to buy the stock at $170 per share, given that it is worth considerably more. As a result, especially for existing investors, shorting OTM puts looks like a profitable way to play this consistently high FCF margin stock.

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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.