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After reporting Q3 revenue and profit numbers on November 8th which exceeded analyst expectations, Nvidia (NASDAQ:NVDA) stock rose in after-hours trading by a few percentage points. This quickly reversed itself the next day as the stock fell by nearly 4% as the company's disappointing guidance for Q4 weighed on the minds of investors. Nvidia projects Q4 revenue to be between $1.025 billion and $1.175 billion, which is less than Q3 revenue of $1.204 billion. As of the close on Tuesday Nvidia traded at $11.83 per share after having broken the $13 mark last week.

NVDA Chart
(Click to enlarge)

NVDA data by YCharts

This dip to levels not seen since May offers an opportunity to buy Nvidia at a bargain price. But an even better price can be had by utilizing one of two simple option strategies. Before I get to that, though, let's estimate the fair value of a share of Nvidia.

Quick Valuation

According to the quarterly report filed by Nvidia for Q3 the company has $3.43 billion in cash and no debt on the books. With a diluted float of 629 million shares this represents $5.45 in cash per share. A full 46% of the company's market capitalization is cash, which means that the market is valuing all future earnings at $6.38 per share. In the fiscal year ending in January 2012 the company reported $770 million in free cash flow, or $1.22 per share. This puts the effective P/FCF ratio at just 5.2. In the current year free cash flow is trailing last year's results, so this ratio is actually a bit higher.

I'll use a discounted cash flow analysis to estimate the fair value of a share of Nvidia. I'll assume that the free cash flow grows from $700 million at a rate of 3% per year, which is essentially no growth after inflation. Using a discount rate of both 12% and 15% to define a fair value range, my fair value range for a share of Nvidia is $15.00 - $18.18. The current market price is 21% below the lower bound of my fair value range.

Option Strategies

Now that we have a rough idea of how much Nvidia is worth we can look at two different options strategies that will allow us to buy shares of Nvidia at prices below the current market price.

Buy-Write

A buy-write strategy is exactly what it sounds like - you buy shares of Nvidia and simultaneously sell covered call options on those shares. The call option lowers your effective purchase price by the premium received, but you risk having the shares called away. Ideally, you want to choose a strike price within the fair value range as to avoid selling your shares for less than they're worth. I'll choose a strike price of $15 dollars since going further out of the money will reduce the premiums substantially. Here are some choices with different expiration dates.

Expiration Date (Number of Days) Premium Effective Purchase Price
Mar 2013 (122) $0.25 $11.58
Jun 2013 (220) $0.49 $11.38
Jan 2014 (430) $1.00 $10.83

The Jan 2014 call option offers a $1.00 premium per share, which lowers your cost basis to $10.83 per share. You are obligated to sell the shares if the option is exercised, which may happen if the stock price rises above the strike price. A shorter term choice is the March 2013 call option, which offers a $0.25 premium.

If the stock continues to fall the price of these OTM call options will fall with it, allowing you to buy them back at much lower prices than you sell them for today and then re-sell them when the stock (and the premiums) rise again.

Put Selling

The second options strategy is selling put options. This method, unlike the buy-write method, does not guarantee that you'll be able to buy the stock. When you sell a put option you sell someone the right to sell you the stock at the strike price on or before the expiration date. Let's choose a strike price of $11 and look at some different options.

Expiration Date (Number of Days) Premium Effective Purchase Price
Dec 2012 (38) $0.25 $10.75
Jan 2013 (66) $0.43 $10.57
Jun 2013 (220) $1.15 $9.85

With this method you are able to purchase the stock only if the market price dips below the strike price and the option is exercised. Otherwise, you don't buy the stock and the premium is payment for tying up funds. While the largest premium in absolute terms is from the longest dated option, the annualized return is the greatest for the shorter-term options. The Dec 2012 put premium offers a 2.27% return on your investment, but an annualized return of 21.83%. In contrast, the Jun 2013 put options offers a 10.45% return on your investment, but only a 17.35% annualized return. If you're able to sell another short-term put after the first one expires worthless then your effective purchase price will be reduced further.

Conclusion

Nvidia stock is undervalued, and the recent dip in prices offers an attractive opportunity to open a position. Using either a buy-write strategy or a put selling strategy will allow you to lower your effective purchase price even further. Both have downsides: the buy-write strategy has the risk of having your shares called away and the put selling strategy has the risk of not being able to buy the shares at all. If the stock rockets higher, say to $18 per share, both strategies will keep you from all of those gains. Regardless of which strategy you use, or if you simply buy the shares outright, Nvidia looks like a bargain at these prices.

Source: Nvidia: 2 Ways To Buy This Bargain Stock For Even Less