Domino's Pizza (DPZ) reported strong Q1 results yesterday including high free cash flow (FCF) margins at almost 10% and 8% FCF growth Y/Y. This makes DPZ stock look undervalued even after its recent surge. Moreover, out-of-the-money (OTM) put options are worth shorting for income.

DPZ stock is at $531.15, up from $477.93 last week when I wrote about the company in my April 23 article, “Domino's Pizza Looks Cheap Ahead of Earnings Results on Monday.” I estimated that DPZ stock was worth $598.00 per share based on 10% FCF margins during 2024. So, at today's price, DPZ stock is still 12.5% undervalued and could be worth more than that target price. More on this below.

Strong Revenue Growth and FCF Margins

In my prior article, I highlighted Domino's strong FCF margins were 10.8% in 2023, up from 8.55% the year before. In Q1 the company made 5.9% revenue growth and its FCF was $103.3 million on $1.085 billion in revenue for the quarter. 

That puts its Q1 FCF margin at 9.6%, similar to last year's average. Domino's is one of the few companies that publishes its FCF. This can be seen on page 2 of the company's earnings release.

Domino's revenue growth of 5.9% in Q1 was higher than the 4.9% Q4 sales growth. In addition, its 10.8% Q1 FCF margin was significantly higher than the 8.7% FCF Domino's posted in Q4. In other words, the company is back on track for good revenue and FCF growth and margins.

As a result, analysts have now raised their revenue estimates for the next two years. For example, Yahoo! Finance has a survey of 33 analysts whose average revenue forecast is $4.81 billion for 2024 and $5.14 billion for 2025. And at Seeking Alpha, the average revenue forecast is $4.82 billion for 2024 and $5.15 billion for 2025. 

This shows that over the next 12 months (NTM) the company could be on a run rate of about $5 billion in sales. So, if Domino's averages a 10% FCF margin it could generate $500 million in FCF on a NTM basis.

Higher Price Targets for DPZ Stock

That implies that DPZ could be worth at least $25 billion using a 2% FCF yield metric. This means that if the company were to pay out 100% of its FCF as a dividend, it could end up with a 2.0% dividend yield. So, dividing the $500 million in FCF NTM estimate by 2.0% produces a $25 billion market cap estimate.

This estimate is 34.9% higher than Domino's $18.5 billion market cap today. That means that DPZ stock is still worth almost 35% more than its price today of $531.15, or $716.52 per share.

Just to be conservative, we might assume that the market eventually gives DPZ stock a 2.5% FCF yield over the next 12 months. That means its market value would be $20 billion (i.e. $500 million FCF / 0.025). This is still 8.1% higher than today's $18.5 billion market value, or $574.17 per share.

So, on average it would be worth between 8.1% and 34.9% more, or about 21.5% higher. That sets its average price target at $645 per share. I suspect that analysts will eventually raise their price targets to this level. For example, AnaChart, a new sell-side analyst tracking service, reports that the average of 33 analysts is $547.96 per share, or about 10% higher than yesterday's close.

Shorting OTM Puts for Income

One way to play this is to short out-of-the-money (OTM) puts for income. In my last article on DPZ, I discussed selling short the $460 and $470 strike prices for expiration on May 17. The premiums were very high at $8.20 and $11.50 per share, providing immediate income yields of 2.14% and 2.45%.

Today, less than one week later, those put options are trading for just 5 cents, so this would have been a huge success for short sellers. But keep in mind that unless the short-sellers already owned DPZ stock, they would have missed out on the huge rise in DPZ stock.

That is why I recommend owning shares in an undervalued stock that you want to short puts in. Even if the stock falls, you should be happy to buy more of the undervalued shares on assignment. But, at least, by owning the shares you get the best of both worlds, the upside as well as the income.

For example, look at the May 24 expiration period. It shows that the $510 strike price puts trade for $3.80 per put contract. That strike price, which is 4.07% out-of-the-money, provides a lower yield now of just 0.745%, compared to the yields available last week. But these are still worth doing.

Moreover, the $515 strike price puts, just over 3.13% below today's price for the next 24 days, allowing an investor who shorts them to make $5.30, or over 1.0% during that period. If the stock stays over $515 in the next three weeks the investor can make this amount and not have to buy shares at $515.

The downside risk is that DPZ could retrace its moves upward. However, I have shown that if the investor repeats these OTM short put trades, they will likely make money as the stock looks deeply undervalued here.

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