Domino's Pizza (DPZ) reported strong Q3 revenue growth on Oct. 10 and expanded free cash flow (FCF) margins. However, management lowered its revenue growth guidance. As a result, DPZ stock looks at least 25% undervalued here at $537 per share. One way to play this is to short out-of-the-money put options.

DPZ closed at $429.67, up over 5% for the day. However, the stock is still well off of its highs seen last quarter. On June 18, DPZ peaked at $533.64. So, in the past four months, DPZ has dropped $103.97, or -19.5%.

However, since Q1 the company's FCF has expanded. That makes Domino's Pizza's value worth much more. This is especially true since analysts are projecting higher sales over the next 12 months. 

As a result, DPZ stock is now worth 25% more, or $537 per share. This article will show why and how to play this.

Higher FCF Margins

Domino's Pizza reported that its Q3 free cash flow reached $376.1 million on $3.2625 billion in sales. That represents an FCF margin of 11.5% for the past three quarters. However, this is not the full story.

That is because, for the past three quarters, its FCF margin has been expanding. For example, in Q1 it made $103.3 million in FCF on $1.0846 billion in sales, or a 9.5% FCF margin. In Q2 its FCF margin was $127.2 million on $1.0977 billion in sales, or an 11.6% margin.

But in Q3, even though sales were lower than in Q2 at $1.0801 billion, its FCF was higher at $145.6 million for the quarter. That represents a 13.5% FCF margin, much higher than the past two quarters.

In other words, the company has been squeezing higher amounts of cash out of its operations, despite flat sales between Q1 and Q3. That has good implications for the company's value.

Valuing DPZ Stock

For example, using a 3.3% FCF yield metric, which is historically what the market has valued DPZ stock, the stock could be worth much more. Here's why. First, let's project the future FCF Domino's will generate. Then we will divide that FCF forecast by 3.3%.

Analysts now project that sales this year will be $4.75 billion and next year it will reach $5.06 billion. That averages $4.905 billion in sales over the next 12 months (NTM). As a result, if we apply a 13.5% FCF margin against that NTM sales forecast, FCF could hit $662 million.

In other words, if the company keeps making an average of 13.5% FCF margin, its FCF could be much higher than what the market currently believes. For example, in the past 3 quarters, the company has generated $376.1 million in FCF. That projects out to an estimate of $501.5 million for the year (i.e., $376.1m/0.75). So, our NTM forecast of $662 million is 32% higher.

Let's use this to estimate the value of DPZ stock. As I mentioned earlier, dividing $662 million by 3.3% (i.e., FCF yield metric) results in a forecasted market cap of $20.06 billion. This is 35.2% over Domino's present market cap of $14.837 billion.

In other words, DPZ stock is worth 35% more at $580 per share. However, just to be conservative, let's assume that the NTM FCF margin comes in lower at 12.5% instead of 13.5%. 

That still results in an FCF estimate of $613 million (i.e., $4.905 NTM sales forecast x 0.125). Using a 3.3% FCF yield metric could lead to a market cap forecast of $18.576 billion. That is still 25% higher than today's market cap of $14.837 billion.

In other words, DPZ stock is worth 25% more, or $537 per share.  One way to play this is to sell short out-of-the-money (OTM) put options.

Analysts Agree DPZ is Cheap, Albeit Less So

Analysts on Wall Street also believe that DPZ looks cheap here. For example, the average price target at Yahoo! Finance is $481.14, and at Barchart the survey shows a mean price of $493.53.

Moreover, AnaChart.com, which tracks recent recommendations from sell-side analysts, shows that 30 analysts have an average $482.39 price target. That represents a $52.72 upside in DPZ stock or +12.27%.

However, to be fair, many analysts have lowered their price targets. For example, look at this table from AnaChart. It shows that a number of analysts have lower their price targets quite significantly. Nevertheless, they still see an upside in DPZ stock.

Shorting OTM Puts in DPZ Stock

For example, look at the options expiration period ending Nov. 8, which is 27 days from now. It shows that the $415.00 strike price has an attractive premium of $5.80 that is worth shorting. In other words, this short-put play yields 1.40% (i.e., $5.80/$415.00) to the short seller. 

Note that the $415.00 strike price is already 3.4% out-of-the-money (OTM) - i.e., below the spot price of $429.67 (see below). So the worst that can happen to the short seller of 1 contract is that they buy 100 shares at 3.4% lower than today's price.

But the breakeven price is much lower, i.e., $415.00 - $5.80 in income already received, or $409.20. That provides good downside protection for the short seller of 4.76% (i.e., $409.20/$429.67-1).

The bottom line is that this is a great way to set a buy-in target price and still receive some income. Moreover, for existing shareholders in DPZ, it provides a way to generate extra income while waiting for DPZ stock to move closer to its target 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.