ConocoPhillips Stock Is Cheap - How to Make a 2.0% 1-Month Yield Shorting COP Puts
COP is at $95.73 in midday trading on Friday, July 11. But it's worth significantly more. I showed that COP was worth $153.60. This article updates that analysis and a way to play it.
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I discussed this play in a June 13 Barchart article, 'ConocoPhillips Stock Looks Cheap with Strong FCF - Shorting OTM Puts Works Here.'
At the time, COP was at $95.56, roughly the same as today, but I suggested shorting the July 11 expiration put option contract at the $90.00 strike price. The premium received was $1.19.
That gave an investor an immediate yield of 1.32% (i.e., $1.19/90.00), but today the premium is down to just 4 cents, making the play very profitable over the last 28 days.
So, it makes sense to roll the trade over. But first, let's look at why COP seems so cheap.
There are 3 reasons why COP stock looks cheap here: a FCF-based valuation, dividend yield target price, and analysts' prices.
In my last Barchart article, I pointed out that ConocoPhillips made a 20.8% free cash flow (FCF) margin. Using analysts' next 12-month (NTM) revenue estimates ($60 billion) implies its FCF could hit $12.48 billion.
Therefore, using a 6.5% FCF yield metric (i.e., roughly twice its 3.25% dividend yield today), its market cap could rise to almost $195 billion:
$12.48b / 0.065 = $192 billion mkt cap
That is +59% higher than ConocoPhillips' market cap today of $120.86 billion, according to Yahoo! Finance. In other words, COP stock is worth +61% more at $152 per share.
Just to be conservative, let's use a lower 18.5% FCF margin and a 7.0% FCF yield metric. That implies $11 billion in forecast FCF and a market cap of $170 billion, or +40% higher (i.e., $135 per share).
COP stock's dividend yield (3.25%) is significantly higher than its historical yield. For example, Yahoo! Finance reports that the historical dividend 5-year yield average is 2.66%. Moreover, Morningstar says its average has been 2.33%.
So, if COP were to revert to its average yield of 2.50%, COP would be worth $124.80 per share, i.e., +30% higher.
However, COP is likely to raise its quarterly dividend to (the last of four payments at 78 cents is coming soon). That means its forward dividend per share (DPS) will be 82 cents per share. Therefore, the next 12 months (NTM) DPS could be $3.24, and its price target is higher:
$3.24 / 0.025 = $129.60
That is +35.3% over today's COP price.
Yahoo! Finance reports that 30 sell-side analysts now have a $116.07 average price target for COP. That is up from $115.73 a month ago, and represents +21% upside from today.
Similarly, Barchart's mean survey price target is $114.88, and AnaChart.com's average is $121.95 per share from 22 analysts.
As a result, the analysts' average target price is about $117.63, or +22.8% higher than today.
The bottom line is that using a FCF method ($135.00), dividend yield ($129.60), or analysts' targets ($117.63), COP stock is worth $127.42, or one-third higher than today:
$127.42/$95.73 = 1.33 = +33% upside
Nevertheless, there is no guarantee this will occur over the next 12 months. Therefore, one way to play it, to make extra income if COP stays flat or falls, is to short out-of-the-money (OTM) put options.
For example, look at the Aug. 15 expiration period, slightly over one month from today. The $92.50 strike price put contract, over 3% lower than today's price, provides a 2% monthly yield.
This can be seen by dividing the midpoint premium of $1.97 by the $92.50 strike price (i.e., $1.97/$92.50 = 0.0213 = 2.13%).
This means that an investor who secures $9,250 with their brokerage firm can enter an order to 'Sell to Open' 1 put contract at $92.50. The account will immediately receive $197, which represents 2.13% of the potential investment (i.e., if COP falls to $92.50).
In that case, the account will be assigned to buy 100 shares with the $9,250. But the investor's breakeven is lower:
$92.50 - $1.97 = $90.53 breakeven
This is over 5% lower than today's price and provides a very buy-in point for an investor. For example, the potential upside is over 40%:
$127.42 / $90.53 = 1.407 = +40.7% upside
Moreover, the investor will make a good annual dividend yield of almost 3.60%:
$3.24 expected NTM DPS / $90.53 = 0.0359 = 3.59% yield
The bottom line is that this is a very good way to play COP stock for investors who are willing to buy shares at a lower buy-in point by shorting OTM 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
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