Costco Wholesale Corp (COST) reported on May 30 that it had stable growth and free cash flow for its fiscal Q3 ended May 12. However, COST stock looks only slightly undervalued, given its recent runup. As a result, the best play here is to sell short out-of-the-money (OTM) put options to generate good income.

COST stock is at $809.89 as of Friday, May 31, up 14.9% from a recent low of $704.88 on April 4. The market was clearly expecting good results and the stock price ran up ahead of the results.

That leaves investors wondering whether to buy this profitable company’s stock now. As I will show below, the best way to play this is to short OTM puts, both as a way to buy in cheaper and generate extra income.

Valuation Issues

COST stock is worth about $869 per share or just 7.3% more based on my analysis of its free cash flow (FCF) and FCF margins. Moreover, it could take a year for that to occur. That does not leave much upside for most investors.

My analysis is based on a 3.5% FCF margin estimate which results in a projected $9.24 billion in FCF over the next 12 months. Using a 2.4% FCF yield metric results in a $385 billion market cap projection. That represents a 7.3% higher valuation than today’s $359 billion market cap.

Moreover, some analysts think the stock may be overvalued. For example, the average price target of 29 analysts surveyed by Refinitiv (shown on Yahoo! Finance’s Summary page) is $796.02 per share. Barchart’s survey shows that the average price target is $783.44. Both of these are slightly below today’s price of $809.89.

However, AnaChart.com, a new sell-side analyst tracking service, reports that the average of 30 analysts is $851.85. That is 4.5% higher than Friday (May 31). This is close to my analysis of $869 for the stock.

Nevertheless, this still does not represent a huge upside for investors in the stock. One way to play it is to sell short out-of-the-money puts.

Shorting OTM Puts for Income

For example, look at the June 21 expiration period for COST put options, which is three weeks away. This shows that the $785 strike price puts, which are over 3.0% below today’s price, trade for $4.45 on the bid side. 

This means that the short seller of these puts can make an immediate yield of 0.567% (i.e., $4.45/$785.00). That is a good income for investors, especially if it can repeated.

For example, keep in mind that the annual dividend yield for COST stock is just 0.57%. In other words, in one three-week period you can make as much income shorting puts as holding the stock for a whole year in dividends.

Moreover, if this investor makes this put yield every 3 weeks for a quarter, they have an expected return (ER) of 2.27% (i.e., 0.567% x 4). This is 4 times the annual dividend yield in just 91 days.

In addition, for investors who don’t want to buy at this price, it allows them to get into the stock at a cheaper price. That would happen if COST fell to $785 per share on or before June 21. That would require the investor to use the cash that was secured to do this short put play to buy 100 shares.

The bottom line is that although COST stock is slightly undervalued it makes sense to short out-of-the-money puts. That way the investor can make extra income and also potentially buy in at a cheaper price.

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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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.