Different Ways Of Generating Income From General Motors

| About: General Motors (GM)
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General Motors offers an intriguing mix of high yield and strong payout coverage.

Previously I have looked at increasing your cash flow on the buying side.

This article looks at the potential to increase your income once you own shares.

In a previous article I highlighted why General Motors (NYSE:GM) could be an interesting income selection, or at the very least a candidate for further research. The first thing to consider is whether or not you'd be happy to partner with the business - without this aspect, no dividend ought to look compelling. To this point, General Motors has shown a renewed life and health in the industry. Still, the previous bankruptcy and short-term payout history could be a cautionary tale for many, so it's important to be content with the business first.

Thereafter, you can start to look at what is being offered. General Motors presently provides a unique mix of a high dividend yield coupled with a low payout ratio. Based a share price near $29, the $0.38 quarterly dividend equates to an annualized yield near 5.2%. To the point of coverage, over the past five years General Motors has earned anywhere from $4 billion to $10 billion annually. The current dividend mark requires $2.3 billion or so before you factor in likely share repurchases.

Previously I talked about the income on the purchasing side - either buying shares outright or getting paid to agree to buy shares via a put option. If you believe in the business, either decision can make a lot of sense. For the remainder of this article I'd like to highlight a third alternative for increasing your cash flow: call options.

Much like being comfortable with a business before you purchase shares, call options are not for everyone. You ought to bring rational thought to the table in deciding whether or not you'd like to pursue this route and determine if it could in fact work toward your goals. So this isn't a recommendation, but instead merely a demonstration of what is out there. I find it prudent to consider a wide range of possibilities, even if you don't intend on pursuing many of them.

To continue with the illustration, let's suppose that you own shares of General Motors and would like to see what types of opportunities are out there to supplement your income. Granted the 5%+ yield is already interesting, but remember this is just as much about exploring possibilities as it is taking action.

Here's a look at some call options that are available for the January 20th, 2017 expiration date:

Note that I have no affinity for this expiration date, but it makes for a reasonable demonstration of agreements a bit out in the future. Many investors prefer shorter agreements, but the above table works well for our purposes.

The first column is the strike price, or the price at which you would be willing to sell 100 shares of General Motors. The second column shows the "net" proceeds that you would receive for agreeing to sell at that price within the next seven months, using the most recent bid less $0.20 per share for frictional expenses.

The third column shows the amount of upfront cash flow that you would receive in comparison to the current share price. And the final column shows the maximum gain that would result from the option agreement alone.

Whether or not you agree to sell above or below your cost basis (the current price for our purposes) has an impact on your total return. As an example, the share price as I write this is $29.05. You could agree to sell at $27 anytime between now and January of next year and receive $300 for every 100 shares you sell. The immediate cash flow yield from this transaction would be 10.3%.

However, as a result of agreeing to sell at a lower price, your total return should the option be exercised would be closer to 3%. In effect, part of the option premium below the current price is analogous to receiving a partial upfront return of capital.

Of course you don't have to agree to sell at a lower price. You can also get paid to agree to sell at a higher price. Let's look at selling at say $32 instead.

If you agreed to sell 100 shares of General Motors at $3,200, today you would receive $65 that is yours to deploy as you see fit. (Note that this could be taxed at a higher rate.) After you make the agreement, one of two things happens: either the option is exercised or it is not.

If the option is not exercised, selling the call will always provide a favorable result as compared to simply holding. A lot of people talk about the idea that a call option does not prevent a loss; which is true. However, it should be clear that your return is going to be superior on the downside. Here I'll show you:

The first column shows a range of potential future share prices. The middle column provides the returns that this would represent if you simply bought and held - which includes two quarterly dividend payments. The last column provides the returns that would result from holding shares and selling the $32 call option.

Note that while the "call" return is not always positive, it is superior to buying and holding for any future value at or below $32. The logic here is very simple. With buy and hold your return is based on the dividends received and future share price. If you sell a call option, your return is based on dividends, the future share price and the upfront option premium. On the downside selling a call option is always going to be ahead by the amount of the option premium that you received.

So an argument against call options because they do not prevent a negative return is not a compelling case. If you're happy to hold anyway the downside is better, not worse, with the call option. Your income will be increased.

A better argument against selling a call option relates to the upside. By agreeing to sell at a certain price, you are "capping" your potential gain. So in keeping with the above example, should you agree to sell at $32 the risk is if shares jump to say $38. In this scenario you would have put in extra time and effort just to secure a lesser return. This is a very real risk, and ought to be considered carefully.

Incidentally, this is why it's so important to be content with either side of the agreement. If you're planning to hold anyway, a lower share price with a call option should not disturb you - your return is going to be better than it would have been by simply buying and holding. What should really be on your mind is the type of return that you'd demand for giving up your shares.

And this goes beyond simple returns. You also want to factor in the quality of the holding, the valuation it represents, the type of future income it could produce, frictional expenses and your ability to adequately replace the holding. These background factors create a higher bar than return alone.

Still, it should be clear that you can be well compensated. In keeping with the $32 call option, should it be exercised, this represents a return of 12% to 15% depending on if you also receive dividends during the next seven months. The decision becomes whether or not this sort of return adequately compensates you for the risk of having to redeploy that capital. Incidentally, if you could consistently find this sort of return, I'd show you an exceptional investor.

So I have now presented three ways to think about generating income from General Motors. You could buy and hold shares, collect the 5%+ dividend and see what happens. You could get paid to agree to buy at a lower price. Or you could increase your income by holding shares and selling a call option. In all three scenarios it's about being content with the potential outcomes while simultaneously working toward your investment goals.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.