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Microsoft Corp. (MSFT) stock is still undervalued, based on its strong free cash flow (FCF) and analysts' price targets. Moreover, out-of-the-money (OTM) MSFT put options expiring in one month can have an attractive 2.0% yield.

MSFT closed at $460.52 on Monday, June 1, up over 2.2%. The stock has been rising since April 29, when the company released its fiscal Q3 earnings.

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I discussed Microsoft's valuation in a May 11 Barchart article, “Microsoft Stock Still Looks Undervalued Based on FCF Projections, Despite Higher Capex.”

I showed in the article that, applying a 53.5% operating cash flow margin (equal to its trailing 12-month or TTM OCF margin) against analysts' revenue forecasts, Microsoft could generate $205.4 billion in OCF.

After deducting expected capex of $106.92 billion, the remaining FCF could be $98.5 billion.

Dividing this FCF estimate by a 2.36% FCF yield metric results in a forecast market value of $4,173 billion, or +20.9% higher than its existing market cap of $3,421 billion.

In other words, MSFT's value over the next 12 months (NTM) is almost $100 per share more, i.e., +20.9% higher, or $556.77 per share:

$460.52 x 1.209 = $556.77 price target (PT)

Other analysts have higher PTs, as well. For example, Yahoo! Finance reports that the average of 56 analysts' PTs is $560.89, and Barchart's mean survey is $553.91. Similarly, AnaChart's survey of 31 analysts, who have written recently on MSFT, $575.69, or 28% higher.

The bottom line is that MSFT stock is cheap, and one way to play it is to sell short out-of-the-money (OTM) puts.

I discussed a one-month short-put MSFT play in the May 11 Barchart article. I discussed shorting the $390 put expiring June 18 for a $5.50 premium, or a 1.41% yield (i.e., $5.50/$390.00). I also discussed shorting the $395 put expiring June 18 for $6.85, or 1.734%.

These put premiums have fallen to just 60 cents and 72 cents, respectively. That means the investor who shorted these puts has made most of the money. It makes sense now to roll these plays over to the next month.

For example, the July 2 expiry period shows that the $440.00 put option strike price, 4.5% below Monday's close (i.e., out-of-the-money), has a midpoint premium of $8.33. That means a short-seller of these puts makes a 1.89% yield (i.e., $8.33/$440.00 = 1.89%).

Moreover, the $445.00 put option contract has a midpoint premium of $10.05, or a one-month yield of 2.258% (i.e., $10.05/$445.00). That means an investor who shorts both contracts will make an average yield of 2.074%.

Note that if the MSFT does fall to $445.00, the actual breakeven buy-in price is lower:

$445.00 - $10.05 = $434.95, or -5.55% below Monday's close of $460.52

The bottom line is that MSFT looks cheap here, and one way to play it is to short one-month expiry out-of-the-money MSFT puts.

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. This article was originally published on Barchart.com