Block Inc. (XYZ) stock shows unusual out-of-the-money (OTM) put option volume today. That is a bullish sign as institutional investors are willing to buy shares at the lower strike price. Given Block's strong free cash flow (FCF), XYZ stock looks undervalued here.

XYZ is at $64.91 today, well off its mid-January peak prices in the low $90s. 

Since then, Block, Inc., the parent of Square, Afterpay, and Cash App, reported strong free cash flow (FCF). That could increase its value, as shown in this article.

Unusual Stock Options Activity Report

Today's unusual out-of-the-money (OTM) put option activity can be seen in Barchart's Unusual Stock Options Activity Report.

It shows that over 18,800 put options traded at the $60.00 strike price. This represents over 163 times more than the prior number of outstanding contracts. That is indicative of strong institutional activity.

The table above shows that the $60 strike price put options, expiring on June 27 (16 days to expiry), have a bid side premium of 45 cents. This strike price is $4.91 below today's trading price, i.e, 7.5% below or out-of-the-money (OTM).

In other words, short-sellers of these puts make income of 0.75% (i.e., $0.45/$60.00) for the obligation to buy XYZ stock at almost 5% below today's price in just over two weeks.

That means they are bullish enough on the stock to be willing to buy it at that price. In return, they make an annualized yield of 16.5% (i.e., 22 x 0.75%) for that obligation, as there are 22 periods of 16 days in a year.

To hedge funds and institutional investors, that is a good expected return (ER). Moreover, Block looks undervalued here. Let's see why.

Strong FCF Generation

Block's Q1 results showed that it has returned to strong FCF generation. In Q1, it produced $725 million FCF on an adjusted basis, up from negative FCF last quarter.

This can be seen in an abbreviated table taken from page 11 of the company's Q1 results below:

It also generated over $1.5 billion in FCF over the trailing 12 months (TTM). Given that its TTM revenue was $23.925 billion (see Yahoo! Finance's “Financials” tab), that works out to a FCF margin of 6.4%:

  $1.526b/$23.925b = 0.0638 = 6.4%

Moreover, during Q1, the FCF margin was much higher:

  $727m/$5,771m = 0.1260 = 12.60%

That means, on average, we could forecast at least a 10% FCF margin over the next 12 months (NTM).

Since analysts now project $25.04 billion in revenue for this year and $27.59 billion in 2026, the NTM revenue projection is $26.315 billion. So, FCF projection is as follows:

  10% x 26.315b = $2.632 billion NTM FCF

That would be over 72% higher than its TTM FCF of $1.526 billion

That could push the value of XYZ stock much higher.

Target Prices for XYZ Stock

One way to value a company is to assume 100% of its FCF is paid out as a dividend. That would give XYZ stock a dividend yield on its $39.727 billion market cap. 

For example, its $1.526 billion FCF represents a FCF yield of 3.84%:

 $1.526b / $39.727b = 0.0384 = 3.84%

That is the same as a multiple of 26x (i.e., the reciprocal of 3.84% - 1/0.0384 = 26.03).

Given the higher FCF forecast for the NTM period (i.e., a potential rise of 72%), XYZ's FCF multiple will rise (i.e., the FCF yield will fall). Let's assume a 30x multiple (i.e., a 3.33% FCF yield):

  $2.632b NTM FCF / 0.0333 = $78.97 billion mtk cap

That is almost twice its existing market cap of $39.7b:

  $78.97b / $39.727b = 1.987x

Even using a slightly higher multiple of 28x, (i.e., a FCF yield of 3.57%) XYZ stock would be worth $73.7 billion. That is still +85.5% higher than today's market cap.

The bottom line is that XYZ stock could be worth between 86% and twice its present price, or an average of +93% more:

  1.93 x $64.91 = $125.28 per share

Analysts tend to agree. For example, AnaChart reports that the average price target of 33 analysts is $108.96 per share.

The bottom line is that Block stock looks to be severely undervalued here, given its strong FCF generation. 

So, no wonder investors are willing to buy it at $60.00 per share through shorting OTM puts. That is seen in today's Unusual Stock Options Activity Report.

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.