In a recent article I detailed the exceptional business and investment history of MasterCard (NYSE:MA). The company grew revenues north of 10% per year and earnings-per-share increased by about 20% per annum. The dividend and share price grew even faster as longer-term shareholders saw annual returns on the magnitude of 30% from 2008 through 2015. Moreover, a robust pace of growth is anticipated to continue.
Of course not all is always rosy. Aside from potential business concerns (upcoming lawsuits, sustainability of exceptional margins, etc.) there are two basic "issues" with the security that an investor must also consider: the valuation and the low starting yield.
The second part is not an issue for a good deal of investors - focusing instead on business performance and trusting this will eventually be reflected in the price. However, for your average income investor a dividend yield starting under 1% is a big stumbling block. As such, in that previous article I demonstrated how you could both own shares of MasterCard and significantly increase the yield that you receive by using call options.
For instance, you could agree to sell at $115 between now and September of next year and collect an extra ~$100 for doing so. If the option is not exercised your cash flow yield is above 2%. If the option is exercised, you're looking at a 30%+ gain in just over a year. There are numerous such possibilities to slightly or significantly boost what appears to be a low starting yield with call options.
The valuation piece was more or less glazed over. Analysts are anticipating 15%+ intermediate-term growth, so a higher valuation multiple appears warranted. Yet it's conceivable that you'd like to own a piece of MasterCard but only at a lower price or better valuation. In this article, let's explore how you could express that sentiment and get paid for doing so.
This table highlights some available put options for the September 2017 expiration date. Note that I have no affinity for this date (many prefer much shorter time horizons) but it makes annual comparisons a bit easier.
The first column illustrates the strike price of the put option or the price at which you'd be agreeing to buy 100 shares of MasterCard. If you don't believe in the company, naturally much lower prices would not be attractive to you. Alternatively, if you want to own shares but just at a lower price, the above table provides an overview of some possibilities.
The second column shows the "net" premium that you would receive for making this agreement. It uses the most recent bid less $0.20 per share for frictional expenses. The third column shows the upfront cash flow yield that this would represent based on the funds required to "cash secure" the option.
The fourth column demonstrates the discount that this strike price would represent (including the premium received) as compared to the current share price quotation near $88.
Finally, the last column presents an "implied P/E ratio" which uses the cost basis for each strike price against next year's projected earnings. The current multiple is around 25 times earnings, so you can see the lower valuations that are represented in addition to the discount column.
Selling a put option is quite like selling insurance. You're collecting a premium today and agreeing to do something in the future under "adverse" circumstances. Actually, in my view, selling put options can be better than selling insurance.
If you sell a homeowner's policy, you collect the premiums and root for that house to never have any damage. Your goal is for the homeowner to never need you to do anything. On the other hand, if you'd like to eventually own shares of MasterCard anyway, it's not as crucial that the share price remain where it is or go higher. For a trader that might be the goal, but a long-term investor has a different set of ambitions.
If you're happy to own shares, the consolidation prize is generating a bit of extra income and not seeing the put option exercised. The real benefit for the long-term investor would be owning shares in a great company at a lower valuation.
Anyway, the reason that you might consider selling a put option as part of a long-term portfolio is to get paid to agree to buy at a lower price.
MasterCard's historical average earnings multiple has been in the mid-20 range over the last decade or so; quite near where it sits today. Of course the growth rate of the company is expected to slow a bit and the valuation has previously reached a multiple in the mid-teens. So you might demand a lower valuation - say something closer to 20 times earnings for the security. Let's see how this could work in practice.
Next year MasterCard is expected to earn $3.60 or so per share. At 20 times earnings, that equates to a share price of about $72. You could set a limit order at this price and see what happens in the year to come. Alternatively, you could get paid to express this willingness to buy.
For instance, the September 2017 put option with a $75 strike price has current "net" bid of about $4.30. Let's see what this could mean.
If MasterCard's share price remains above $75 it would be unlikely that the option would be exercised (why sell to you at $75 when you could sell in the market for $75+?). If you had a limit order, nothing would happen. Your price was not hit, you collect no income and have no shares.
Alternatively, if you sold the put option, you would immediately collect ~$430 in option premium, representing a 5.7% yield that can instantly be redeployed or utilized as you see fit. (Note this premium could be taxed differently than qualified dividends or long-term gains.) You still don't own shares of MasterCard, but you do have an extra $430 to work with by expressing the willingness to buy at that price. Depending on your alternatives to allocate capital, that's not the worst of consolation prizes.
If MasterCard's share price does go below $75, the option could be exercised - forcing you to buy 100 shares of the company. In this case your cost basis would be closer to $71; representing a 20% discount from today's price and equating to an implied earnings multiple of just under 20. Mission accomplished: you bought shares in an excellent business at a lower valuation.
Some might point out that this does not prevent against a loss, which is true. Should the share price drop to $60, you'd be stuck buying at $75. That's why it's important to be content with both sides of the agreement. All too often options get a bad reputation as a trading tool, but you can get paid to make an agreement with a long-term view as well.
In short, MasterCard has thus far proven to be an exceptional business and investment over the years, with solid growth prospects expected to continue. The problem that many investors have with the security is the valuation and the low starting yield. We've previously addressed the low starting yield and this article demonstrates how you can earn additional income by agreeing to buy at a lower price.
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.