Microsoft Corp (MSFT)

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Microsoft (MSFT) Could Make $100 Billion in Free Cash Flow, Leaving MSFT Stock Undervalued
By: Barchart | October 27, 2023

Microsoft (MSFT) delivered very profitable quarterly results on Oct. 24 for its fiscal Q1 ending Sept. 30. Given its high free cash flow (FCF) margins, it is now on track to deliver between $90 and $100 billion in FCF over the next 12 months. To some investors, that leaves MSFT stock undervalued.

The company said its revenue was $56.5 billion, up 13% year-over-year (YoY). Moreover, the free cash flow (FCF) generated from this revenue was $20.7 billion, as reported on page 6 of its earnings slide presentation.

This FCF was 22% over last year's figure, showing that Microsoft is growing in its ability to generate cash.

More importantly, it also shows that 36.6% of revenue turned into FCF. That is a very high FCF margin. This portends very good things for MSFT stock going forward.


MSFT Q1 2024 Fiscal results (ending Sept. 30, 2023)

This result was on par with the results it had last quarter, as I described in my previous Barchart article on Sept. 17, “Microsoft is Still Cheap Based on Its Free Cash Flow.” After adjusting for a one-time tax payment, it made $21 billion in FCF, which worked out to a FCF margin of 37.4%.

So, over the past two quarters, its average FCF margin has been 37%. We can use that to set a price target for MSFT stock.

Price Target Based On FCF

Analysts project that Microsoft will make $242.2 billion in revenue this fiscal year ending June 2024 and $274.7 billion next year. So, if we apply the average 37% FCF margin to these figures, FCF could range between $89.6 billion and $101.6 billion over the next 12 months.

That implies that the company continues to grow its revenue, earnings and free cash flow over the next 12 months. It means that FCF could exceed $100 billion, or that analysts will begin predicting this kind of number on a run-rate basis.

That has huge implications for the stock's value. For example, if we use a 3% FCF yield (which is the same as multiplying FCF by 33.3x), its market cap could reach $3.33 trillion.

This is significantly higher than its present $2.44 trillion market cap. It implies that MSFT could rise by 36.4%.

Even if we use a 4.0% FCF yield (i.e., 25x FCF), Microsoft will be worth $2.5 trillion sometime in the next 12 months, or +2.5% from today In other words, the stock might rise between 2.5% and 36.4% based on its FCF generation.

That implies that MSFT stock is worth on average about 19.5% more than today or $400 per share (i.e., 1.195 x $334.40 price today).

Shorting OTM Puts For Extra Income

One way to take advantage of this is to short out-of-the-money put options to generate extra income, all while holding the underlying shares in MSFT. For example, the Nov. 17 put option expiration period shows that the $320 strike price puts, which are over 4% below today's spot price, trade for $3.18 in the midpoint.

That implies that short-put traders can make an immediate 1.0% yield (i.e., $3.18/$320 = 0.994%).

On an annualized basis, this means the expected return is 16.89% (i.e., 0.994 x 17), since there are 17 three-week periods in a year.


MSFT Puts - Expiring Nov. 17 - Barchart - As of Oct. 27

This shows that investors who hold MSFT stock long can make extra income without having to worry that their shares could be called away. The worst that would happen here is that the investor would be forced to buy more shares at the $320 strike price.

But in the meantime, they get to keep the 1% yield, effectively lowering the breakeven price to $316.28 per share, or slightly over 5% below today's price. That is very good downside protection.

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