Nvidia Stock Looks Too Cheap Here - Put Premiums are Very High and Worth Shorting
Mark R. Hake, CFA - Barchart - Sun Apr 21, 12:39PM CDT
Nvidia Inc. (NVDA) stock has taken a tumble since the end of March but it looks too cheap now. Moreover, its put premiums are sky-high. This makes them worth shorting both for income and with low buy-in strike prices. That applies to out-of-the-money puts whose near-term premiums are at very high levels.
NVDA stock closed at $762 on Friday, April 12, 2024, down $188.02 or 19.8% since March 25 when it was at $950.02. Moreover, on Feb. 22, the day after it released earnings on Feb. 21, NVDA stock was at $785.38. However, that was up $110.66 or 16.4% from the day before earnings came out.
The point is that the market seems to think Nvidia will face harder times in its AI chip-designing business. The problem is that doesn't line up with analysts' revenue forecasts, and by inference, its free cash flow (FCF) estimates.
NVDA Stock Looks Cheap Here
I have discussed this in several Barchart articles such as this one on March 29, “Nvidia Stock Could Still Be Worth 26% More at $1,141 - Good for Short-Put Plays by NVDA Investors.” And before that I wrote this article on Feb. 25, “Nvidia Stock Could Be Worth 42% More at $1,120 - Put Short Sellers Find This Attractive.”
In these articles, I projected sales and free cash flow (FCF) for Nvidia for the next year or longer. Based on the company's massive 50% FCF margins, it's possible to project a significantly higher valuation for the stock.
For example, analysts project $111.56 billion in revenue for the year ending Jan. 2025 and $136.17 billion for next year. So, sometime in the next 12 months (NTM), Nvidia will be on an average revenue run rate of at least $123.87 billion.
Therefore, if Nvidia keeps making 50% FCF margins as it did last quarter, free cash flow will be at least $61.9 billion (i.e., 0.50 x $123.87 billion). Even if it averages just 45% FCF margins, FCF will rise to $55.7 billion, which is still over twice the $26.95 billion it made in FCF last year.
If the market values NVDA stock at a 2.5% FCF yield metric, which is the same as a 40x FCF multiple, the stock's value will be between $2,228 billion and $2,476 billion. This is estimated by multiplying the 45% and 50% FCF margin estimates (i.e., $55.7b and $61.9b) by 40. So, the average estimate for Nvidia's market cap over the next 12 months is $2.352 trillion and potentially as much as $2,476 billion.
That average value is still 23.66% higher than its existing $1.902 trillion market cap today with an upper value that is 30.1% higher. In other words, NVDA stock is worth at least $942 per share (i.e., 1.2366 x $762), and could be worth as much as $991 per share or more. And next year, that valuation could rise as well if the company continues to make higher revenue and FCF.
Shorting OTM Puts
Right now NVDA stock, having dropped so far and fast, has very high put option premiums. This makes them worth shorting both as an income play, especially for existing investors, and also as a good entry point for new NVDA stock buyers.
For example, look at the May 10 expiration period, which is 3 weeks away. It shows that the $725 strike price, which is almost 5% below the price on April 12, is trading for $21.10 per share. Moreover, even the $710 strike, which is over 6.8% below today's price, has a $16.65 premium on the bid side.
That means that any short sellers of these put options can make immediate yields of 2.91% (i.e., $21.10/$725.00) and 2.345% (i.e., $16.65/$710.00) over the next three weeks. These are very high yields and provide very good downside protection to the short sellers.
For example, even if the stock falls to $710 by May 10, the investor, who is obligated to use the cash that was secured to do the short sale, still has a profit, since their breakeven price would be $710-$16.65, or $693.35 per share. That represents an expected return (ER) of 2.40% before commissions (i.e., $710/$693.35-1).
And the $725 strike price investor knows that no matter what, even if the stock falls to the strike price, his breakeven price is $725-$21.10, or $$703.09. If the investor does not already own NVDA stock they may be happy to continue holding it here at this cheap buy-in price. That is because they can see that it could be worth substantially more over the next 12 months if the company keeps generating strong FCF margins.
Downside Risk
Nevertheless, even if NVDA keeps falling, possibly from strong competition concerns, the investor has ways to improve their situation. For one, look at this play. The investor could short the $725 strike price put option and buy the $710 put as a long investment. That means that, given that the breakeven for the short sale is $720.55 per share (-i.e., $725-$16.65+$21.10).
That leaves the investor exposed to just the width between $710 and $720.55 over the next 3 weeks. That may be deemed an acceptable risk, especially if NVDA rebounds, given its strong FCF. Moreover, by May 21 the company is likely to report its quarterly earnings, so they may not find it unacceptable to keep holding the shares that they were obligated to buy.
One technique to narrow this potential risk is to manage the long-term purchase. If the stock starts to rise, it makes sense to sell the puts as they lose value.
In addition, even if the puts are exercised at the $725 strike price, the investor can later sell out-of-the-money calls. For example, in last month's article, I recommended shorting the $880 puts for $25.50 expiring on April 19, for a breakeven buy-in price of $854.50. Those puts were likely exercised, and the investor now has an unrealized loss of $92.50, or -10.8%.
So now, they can sell call options at say $20.00 (see the May 10 call option expiry chain) for the $810 strike price. Even if those are exercised the net loss is just $830.00 (i.e., $810+$20.00) - $854.50, or -$25.54, which is now a loss of just 3.0% (i.e., $-25.54/$854.50). If this is repeated one more time in another 3 weeks, the investor can potentially recover that loss.
Moreover, if they continue to short OTM put options, the investor can lower their buy-in price and gain extra income. The bottom line is that NVDA stock looks very cheap here and shorting OTM puts is a good way to buy in at a low price and also gain income.
