Shopify Inc. (SHOP) posted excellent results for Q4 on Feb. 13 and highlighted that its FCF margins jumped to 21%, from 16% in Q3.  Accordingly, SHOP stock could be worth 20% more. Short-put plays for income are popular with existing shareholders.

SHOP stock is at $79.06 today, having fallen after yesterday's market selloff. But it's possible that the stock could be worth at least 20% more at $95.27 per share based on its powerful FCF margins. We will delve into this below.

FCF Margins Skyrocket

Shopify said that Q4 revenue was up 23.5% YoY from $1.735 billion last year to $2.144 billion in 2023. This was actually up 30% after adjusting for the sale of its logistics business.

Moreover, the company said its free cash flow (FCF) rose from $90 million last Q4 to $446 million in Q3 2023. That works out to 20.8% of revenue (i.e. $446m/$2,144m) up from 5.2% last year.

In addition for the full year its FCF generation reached $905 million, up exponentially from negative $186 million last year. This can be seen in the table below from page 15 of the company's Q4 release.

This has huge implications for the company's forward-looking FCF forecasts. For one, the company itself projected on page 5 of its release that in Q1 its FCF would rise:

“Free cash flow as a percentage of revenue to be in the high-single digits, with sequential improvement every quarter throughout the year.”

That implies that its FCF margin will approach 20% and likely hit 22% to 23% by year-end. That implies that its full-year average will be 21% or so.

As a result, we can forecast its forward FCF for 2024. For example, analysts now predict revenue will hit $8.53 billion in 2024 and $10.16 billion by 2025 year-end. That means that its run-rate next 12-month (NTM) average going forward by the middle of this year will be $9.35 billion.

So, if we apply a 21% FCF margin against this, free cash flow could rise to almost $2 billion (i.e. $9.35b x 0.21 = $1.96b). This has huge implications for the value of SHOP stock.

Target Price Using FCF Yield Metric

For example, let's assume that the company paid out 100% of its FCF as a dividend. What would the dividend yield be? It would likely be at least 1.5% and possibly lower. 

Therefore, if we divide $1.96 billion by 1.5% we get a market cap valuation of $130.6 billion. That is 28.5% over its present $101.6 billion market cap (i.e., 1,286.6 billion shares o/s x $79.00 per share).

But, just to be a little more conservative let's use a 1.60% FCF yield metric. So, that implies its market cap will rise to $122.5 billion (i.e., $1.96b/0.016). That is 20.6% over today's market value and implies that the target price is $95.27 per share.

The bottom line is that investors can expect to see a higher price. One way they can patiently wait for this to happen is to short out-of-the-money put options to gain extra income.

Shorting OTM Puts for Income

The reason is that Shopify's put option premiums are very high now. So why not short them in near-term expiry periods and out-of-the-money (OTM) strike prices. That allows investors to gain extra income while they wait for a higher target price.

For example, look at the March 1 expiration period, which is a little over 2 weeks from now (16 days). It shows that the $75.00 strike price, which is 4.35% below today's stock price, trades for $1.36 on the bid side.

That implies that the short seller of these puts can make an immediate yield of 1.81% (i.e., $1.36/$75.00).

This means that the short seller who secures $7500 in cash and/or margin with their brokerage firm can enter an order to “Sell to Open” 1 put at the $75 strike price. Their account will immediately receive $136.

In fact, if they can do this 6 times over the next quarter, they will earn a total of $816.00. That represents an expected return (ER) of 10.88% of the $7500 invested over that period. 

And just to be more conservative, they can short the $73.00 strike price puts (see above) for 85 cents. That represents an immediate yield of 1.16%. The investor can potentially make an expected return of $510 over 12 weeks if this trade can be repeated. That represents a potential ER of 6.80% (i.e., $510/$7,500).

Downside Risk

Keep in mind that if the stock falls to $75.00 or $73.00 these puts will be exercised. That means the investor's secured cash will be used to buy 100 shares at those strike prices. It could result in an unrealized loss. 

However, an investor in SHOP stock will have the comfort of knowing that SHOP stock is deeply undervalued at that price given our FCF yield price target. Moreover, they can also potentially turn around and sell covered calls in the out-of-the-money (i.e., higher) strike prices. That produces extra income that could improve the unrealized loss.

The bottom line is that SHOP stock looks inexpensive here. One way to pay this is to buy the stock and short OTM puts while waiting for the stock to rise.

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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.