PayPal (NASDAQ:PYPL) Holdings (PYPL) produced strong Q3 free cash flow (FCF) results for Q3 on Oct. 29. LEAPS (i.e., long-dated calls) are an alterantive play here rather than just PYPL stock. This article will describe why.
As of Nov. 7, PYPL was at $81.35, with an $81.8 billion market cap. This article will show why it could be worth over 30% more, or $106 per share with a $91+ billion market valuation.
My thesis is simple: PayPal's strong FCF and FCF margins will push PYPL stock higher.
As a result, call options with expiry periods over one year from now, known as LEAPS (long-term equity anticipation securities), look like a potential opportunity here.
PayPal's Strong Free Cash Flow (FCF)
PayPal is one of the few companies that focuses on its free cash flow (FCF) performance:It reports its quarterly nominal FCF figure
It reports its adjusted FCF figure and explains how it adjusts the nominal FCF
It shows the quarterly FCF growth rate on a year-over-year (YoY) basis
It shows how each quarter's adj. FCF dollar value is calculated
It provides an annual FCF target number
This is by far much more information than many other companies provide. The only metric an analyst needs to calculate is its FCF margin (i.e., FCF / revenue).
(Note: Free cash flow is defined as operating cash flow, which includes EBITDA plus net changes in working capital, less capital expenditures).
FCF is a very good measure of how much cash a company throws off and is free to be spent on buybacks, dividends, acquisitions, etc.
Q3 Adj. FCF and Margins
Last quarter PayPal said its FCF was $1.445 billion, and after one-time adjustments, $1.540 billion.One page 2 of its press release, PayPal said this FCF was 31% higher than the prior year's $1.1 billion. Its adj. FCF was 19% lower last year at $1.911 billion. However, its adj. FCF is still higher than FCF.
Moreover, PayPal's shareholder deck has a very interesting table which shows how its FCF and adj. FCF has been growing over the past 6 quarters (see below):
This table, taken from page 19 of its deck, shows that over the last 12 months (LTM) adj. FCF was $5.43 billion.
Based on figures from page 25 of its deck, this was 19.2% higher than the $4.554 billion in 2023 adj. FCF.The LTM $5.43 billion in adj. FCF works out to 17.3% of its LTM revenue, i.e., a 17.3% FCF margin. That can be seen from its LTM revenue taken from page 16 of its shareholder deck (see below):
The point is that PayPal generates large amounts of cash from its operations, growing about 19% annually.
Projecting FCF for 2025
PayPal indicated on page 11 that it expects to make $6 billion in FCF in 2024. PayPal has already produced $4.576 billion in FCF (see the first table above, i.e., Q1 $1.763b, Q2 $1.368b, Q3 $1.445b).Therefore, this implies that Q4 FCF will be $1,424b (i.e., $6.0b - $4.576b). This is similar to the $1.45 billion from Q3. So, we can assume adj. FCF will be $1.450 billion or so.
As a result, since YTD adj. FCF is $4.536 billion (see above), and for 2024, FCF is forecast to be $6.076 billion:
YTD adj. FCF $4.536 billion
+Est. Q4 adj. FCF $1.500 billion
= Total (EPA:TTEF) 2024 adj. FCF $6.036 billion
Since analysts are projecting 2024 revenue of $31.73 billion, its adjusted FCF margin will be about 19.0% (i.e., $6.036b adj FCF/ $31.73 b est. 2024 revenue).
That is useful since we can use that estimate to project 2025 adj. FCF. For example, analysts forecast $33.61 billion in revenue. So, here is what we can predict:
0.19 adj. FCF margin x $33.51b 2025 sales = $6.386 billion adj. FCF in 2025
Note this is 17.6% higher than the $5.43 billion in adj. FCF PayPal produced in the last 12 months (LTM) see above. That implies the stock could be worth significantly more over the next 12 months (NTM). Here's why.
Price Targets for PYPL Stock
Analysts can value a stock by using a FCF yield metric. This measure assumes that 100% of the adj. FCF is paid out to shareholders.That way we can set a yield metric. For example, PayPal's LTM adj. FCF of $5.43 billion represents 6.64% of its presents $81.8 billion market capitalization:
LTM adj. FCF $5.43b / $81.8b mkt cap = 0.06638
So, let's use this to estimate its next 12 months (NTM) valuation. For example, using the NTM adj. FCF, which is over 17% higher than the LTM figure, we can assume the market will raise the FCF yield metric.
One way to raise the metric is to lower the FCF yield slightly. For example, let's assume that the market will value PYPL stock with a simple 6.0% FCF yield (down from its 6.64% LTM figure):
$6.386b est. 2025 adj. FCF / 0.060 = $106.43 billion market value
That is 30% higher than its present $81.8 billion market cap. In other words, PYPL stock could be worth +30% more than today's price of $81.65, or $106.15 per share.
Analysts agree that PYPL stock is undervalued. For example, Yahoo! Finance's analyst survey shows a mean price of $89.03.
AnaChart.com, a new site that tracks analysts' price targets (as if they were stocks) shows that the average of 37 analysts covering PYPL is $102.91 per share. That is 26% higher than today and is close to our 30% higher price target of $106 (explained above).
The bottom line is that over the next year PYPL looks undervalued based on its strong FCF and FCF margins.
An alternative play is one-year-out call options with "in-the-money" (ITM) prices.
In-the-Money LEAPS
For example, look at the Dec. 19, 2025 call options expiration period. That is over one year from now. So, if you hold the call options and later sell after one year, you won't have to pay short-term taxes.The $70 call strike price, which has a huge number of contracts outstanding and hence good liquidity, has a mid-price of $19.95. To simplify things, let's call it $20.
That means the investor pays just $20 x 100, or $2,000 to control 100 shares, rather than $8,131 (i.e. 100 x $81.31).
Moreover, these are 14% in-the-money (ITM), i.e., they have intrinsic value. That is because the strike price is $11.31 lower then the trading price of $81.31, so
$11.31/ $81.31 = 0.139, i.e., 13.9%
This gives the investment some stability and inherent value. But note, the breakeven price is still high. Here is why:
$70 strike price + $20 call premium = $90.00 breakeven (BE), or $8.69 over $81.31;
$8.69 / $81.31 price today 1 = +10.7%
So, PYPL stock has to rise over 10.7% over the next year for these options to have any intrinsic value upon expiration.
Leverage and Downside Risks
But note that the leverage is quite high. For example, the delta is 0.76. That means that for every dollar gain in PYPL, the calls will rise by $0.76, or $76 to the investor (i.e., 100 shares per call x $0.76).In other words, if PYPL rises to $101, or $20 higher, it's possible that the calls will trade around $35.00:
$20 x 0.76 delta = +$15.20, so $20 call price today+$15.20 = $35.20
That implies a gain of 76% (i.e., $35.20/$20.00-1 = 1.76-1 = 0.76) for just a 25% gain in the stock price (i.e., $101/$81-1 = 0.247).
Moreover, the calls have some downside protection. PYPL stock would have to fall by over $11.00 before the calls have zero value. That implies that these calls have 13.9% downside protection.
Moreover, the call options expire in over a year. That provides plenty of time for the stock to recover.
Lastly, all calls have extrinsic value. The investor could roll these calls into a longer-dated option, taking some loss. That way the calls could recover from any deterioration in PYPL stock.
This shows why LEAPS, i.e., long-dated options in PYPL stock could be a good play. Given PayPal's huge free cash flow generation over the coming year, a leveraged security play could make sense. It matches the time frame in which FCF could be expected to occur.
This is not investment advice. No one should rely on our projections or recommendations in relation to these options for their own personal financial situation.
This content was originally published on Gurufocus.com
