Use Puts To Buy These Value Stocks

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although options can be extremely risky, selling put options can be a fairly conservative way to generate income or to buy stocks at a pre-determined price. It's advisable to only do this for stocks that you'd be happy owning at the strike price - otherwise you could end up with a cost basis far above the intrinsic value of the stock. Here are three stocks that I've written about recently which are undervalued and have attractive put options.

NVIDIA (NASDAQ: NVDA) - I wrote recently that NVIDIA is deeply undervalued, with a large amount of cash and a robust free cash flow, and valued the stock between $16 and $20 per share. If fact, even under a no growth scenario the stock would be worth about $13 per share, higher than the current share price. Nvidia has about $3.73 billion in cash on the books, roughly $6 per share, meaning that cash represents almost half of its total market capitalization. With just over $1 of annual FCF/share, that puts the P/FCF ratio after subtracting out cash at 6.1. This seems outrageous given NVIDIA's dominant market position in graphics processors.  

Now, your goal determines what strike price at which you should sell a put option.

If you want to buy the stock, then you can sell an at-the-money put option. The $13 strike price is slightly above the current stock price, meaning that if the stock stays flat through expiration you would be put the shares at $13 per share. If the stock price rises above $13 then the option would expire as worthless. The April $13 put option comes with a premium of $56 per contract, which would make your effective purchase price $12.44 if the option is exercised. If the option expires worthless, the premium represents a 4.3% return in 38 days.

If you want to generate income then you can sell an out-of-the-money put option. This creates a buffer so that the stock price would need to fall before the option is exercised. The April $12 put option comes with a premium of $15 per contract. The stock would have to fall about by about 6% from the current market price as of this writing for the option to be in the money. If the stock remains flat, then the premium represents a 1.25% return in 38 days, or 12% annualized.

Another option is the June $11 put option. This offers a larger buffer of about 13% in exchange for a lower annualized return of 7.2% over 101 days based on a premium of $22 per contract.

Cisco (NASDAQ: CSCO) - Cisco is in a similar situation as NVIDIA, with a lot of cash on the books and a strong cash flow. I put the realistic fair value of a share of Cisco at a minimum of $25 per share, meaning the stock is currently undervalued by about 17%. Cisco has a net cash position of $30 billion, or $5.60 per share, making up 26% of the total market capitalization. And with over $10 billion in FCF per year, the P/FCF ratio adjusted for cash is about 8.5. Cisco absolutely dominates its core markets, with a wide moat and a renewed focus after years of sub-par acquisitions.  

If you want to buy the stock then you can sell the April $22 put option. The strike is just slightly above the current market price, meaning that the option will be exercised if the stock price remains the same. A premium of $68 per contract knocks your effective purchase price down to $21.32 if the option is exercised. Otherwise the premium represents a 3.09% return over 38 days.

If you want to generate income then you can sell the April $21 put option. The buffer against exercise is about 3.2%, and the premium of $24 per contract represents a 1.1% return over 38 days, or 11% annualized.

If you want a bigger buffer against a stock decline you could sell the June $20 put option. The buffer here is 7.8%, and the premium of $39 per contract represents a 1.95% return over 109 days, or 7% annualized.

Western Union (NYSE: WU) - Western Union is the king of the money transfer industry, and when I wrote about the company here I valued the stock at $19 per share at the high end, compared to a current share price of about $14. Western Union operates in an industry where size matters because most of the costs are fixed. With annual FCF around $1 billion, about 16% of revenue, Western Union is the 800 lb. gorilla of the money transfer business. Another big plus is a solid dividend yield of 3.43%, which increased by 25% in December of 2012.

If you want to buy the stock then you can sell the April $14 put option. This is barely below the current share price, and if the stock drops below $14 your effective purchase price will be $13.55 per share with the $20 premium. If the option expires worthless your return is 1.4% in 38 days.

If you want to generate income then you can sell the May $13 put option. This option gives your a 10.3% buffer against a stock decline and the $20 premium represents a 1.5% return over 73 days, or 8.5% annualized.

Another option is the May $12 put option. This gives you a bigger buffer of about 17% against a price decline while reducing your annualized return to 4.6%.

The Bottom Line

Selling put options on undervalued stocks is a conservative way to either set the purchase price and receive a premium to wait for the stock price to fall or to generate income. Even if the stock is put to you you're buying a quality company at a discount to its intrinsic value. If the options expire worthless you can easily generate a double-digit annualized return. It's a win-win.

TheBargainBin owns shares of Cisco and Western Union. The Motley Fool recommends Cisco Systems, NVIDIA, and Western Union. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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