Generating income with options on Facebook shares
Rule 1: Never leverage Rule 2: You want to own Facebook
I’m pleasantly surprised to see that the newsletter exploded to 459 subs in less than 24 hours. To welcome the new subscribers, I will share how I used options to generate income while waiting for Facebook shares to hit my target price.
Please share this with your friends if you found it helpful!
Options when used as a tool for long-term investing has 2 benefits:
Lowers your purchase price
Generate income for you
Let me illustrate with one of my trades on Facebook. My back of the envelope valuation is at the end of this newsletter.
Facebook trade I did
*Not Investment Advice*
Facebook (FB) currently trades at a reasonable/ cheap valuation—$250 at the time when I write this. As it is already one of my core position, I will add to it only if it goes below $230.
I sold a put contract, with a strike price of $235, expiring on 26 Feb 2021, for $7. This means that on 26 Feb, I would be obligated to buy 100 shares of FB at $235.
Two outcomes may happen:
If FB trades above $235, I will pocket the premium of $700 ($7 x 100 shares) without owning FB shares.
If FB trades below $235, I will pocket the premium of $700. But I will also have to buy 100 shares of FB.
Outcome 1 is straightforward, you generated an income of $700 but you do not get to own FB.
Let’s explain outcome 2 further. I previously mentioned I’m willing to own FB if it’s below $230, so why did I set a strike of $235?
The premiums collected (i.e. $7) lowered my purchase price!
If my put options get exercised, I effectively own FB at $228 ($235 - $7).
This way, I get paid $700 in premiums while waiting for FB to hit my target price!
Rules to abide by
Rule 1: Always have cash when selling put. Because if I get exercised at $235, I will have to buy 100 shares of Facebook. I made sure to have $23,500 on standby.
Rule 2: Do your fundamental work. Only sell put if you want to own the company. I believe FB is underpriced and I’m willing to add if it goes below $230.
Rule 3: Trade only if it provides annualized returns of at least 24%. Collecting $700 premium on capital $23,500 provides for approximately 3% in 1.3 months, or 28% when annualized.
Valuation of Facebook
This is my rough back-of-the-envelope valuation of Facebook written on 16 Jan 2021.
You can read my business breakdown of Facebook on SteadyCompounding.com
Facebook currently sells at $250 per share or 24 times consensus 2021 earnings estimates of $10.47 per share. This is extremely reasonable for a high-quality company.
They are expected to have $29 per share of cash at the end of 2021. Substracting cash from the stock price, we are only paying $221 per share or 21 times earnings.
Facebook paid $19 billion for Whatsapp back in 2014 and its subscriber numbers have since quadrupled. If we assume that the value of Whatsapp has not grown at all, it would be worth $7.75 per share. However, if we assume that the value of Whatsapp has grown with its subscriber count, then it would be worth $31 per share.
In addition to Whatsapp, let’s assume Occulus and FB’s investment in augmented reality/virtual reality (AR/VR) is worth what they cost—approximately $5 per share, then we should deduct between $12.75 to $36 from Facebook’s stock price.
In essence, we are paying between $185 to $208.25 for Facebook and Instagram business, after stripping out Whatsapp and Occulus. A P/E of only 17.7 to 20 times, which is way lower than the S&P 500.
For a high growth, free cash flow generative monster like Facebook, this is a bargain.