eBay Inc. (EBAY) stock showed large, unusual trading volume today in call options that expire on Friday. Given its strong free cash flow generation, EBAY stock is an attractive play and could be worth 21.5% more at $87.87 per share over the next year. This article will show why.

EBAY is at $72.32 in midday trading on Wednesday, May 28. That is a new 6-month high and indicates bullish sentiment in EBAY. The heavy call options are out-of-the-money but could result in a profitable trade for buyers by Friday if EBAY keeps rising.

Today's Barchart Unusual Stock Options Activity Report shows the heavy trading volume in EBAY calls at the $74.00 strike price for expiry on May 30. Almost 12,000 call option contracts have traded at that strike price, representing over 75 times the prior number of contracts outstanding.

This implies heavy institutional interest in EBAY stock. Let's look at what they may find interesting.

Strong Free Cash Flow Generation

eBay reported on April 30 that its Q1 revenue and non-GAAP both rose 1% YoY, although its non-GAAP earnings per share (EPS) was up 10%. The latter was higher due to share repurchases.

The company has plenty of free cash flow (FCF) to keep buying back shares. For example, for the quarter, its FCF was up 36%, as seen in the table below.

It also shows that the FCF margin (i.e., FCF/revenue) rose dramatically from 18.5% last year to almost 25%, despite the relatively flat revenue growth. In other words, the company is squeezing out much more cash from its operations. 

That bodes really well for eBay's valuation going forward. For example, we can use that to project FCF using analysts' revenue forecasts and then use that to set a value.

For example, 27 analysts surveyed by Yahoo! Finance project $10.62 billion in revenue this year and $10.97 billion next year. That implies its next 12-month (NTM) run rate is $10.8 billion.

So, assuming eBay can make an average of 21.7% FCF margins (the average over the last year - i.e., (24.9% +18.5%)/2), it may generate $2.34 billion in FCF:

  0.217 FCF margin x $10.8 billion NTM revenue = $2.436 billion FCF

So, how will the market value this FCF estimate over the next 12 months (NTM)?

Valuing EBAY Stock - Setting Price Targets

One way to value EBAY stock is to use an FCF yield metric. This assumes that 100% (theoretically) of FCF is paid out to shareholders in dividends. What would the dividend yield be?

Well, right now its dividend yield is 1.60% (i.e., $1.16 dividend per share/$ 72.32 = 0.01604). But, this can't be used as the FCF yield. It's too low. Why?

In Q1, only $134 million was spent on dividends, as seen in its cash flow statement. That is only 20.8% of the $644 million Q1 FCF.

In other words, we have to “gross up” the dividend yield by 4.8x (i.e., 1/20.8% = 4.807). In other words, the FCF yield should be 7.68% (i.e., 1.60% x 4.8x). To simplify this, let's use a 7.50% FCF metric.

So, to set a value for EBAY stock, we can divide the NTM FCF estimate by 7.50%, which is the same as multiplying it by 13.33x (i.e., the reciprocal of 7.50%):

  $2.426b FCF  x 13.33 = $32.34 billion market value

That is close to today's market value of $33.28 billion, according to Yahoo! Finance.

However, is 13.33x the most likely multiple the market will use, given that its FCF margins have expanded so much? The FCF yield is likely to be lower. For example, Morningstar reports that its average 5-year dividend yield has been 1.49%, compared to today's 1.60% dividend yield.

Therefore, it's more probable that there will be a lower FCF yield, i.e., at least a 15 - 18x multiple will occur. 

This means that using a 6.0% FCF yield (i.e., a 16.667x multiple, since 1/0.06 = 16.67) is more appropriate:

  $2.426b FCF x 16.667x = $40.44 billion market cap

That is 21.5% higher than today's market value of $33.28 billion. In other words, EBAY stock is worth 21.5% more than its price today:

  $72.32 P/sh x 1.215 = $87.87 price target

The Bottom Line

Analysts tend to agree. For example, AnaChart.com reports that the average of 26 analysts' price targets is $76.61. That is +5.9% over today's price.

The bottom line is that EBAY looks relatively cheap today. That could be one reason why there is heavy volume in EBAY call option trading today.

However, investors should be careful in copying this trade. For example, our analysis of the value of EBAY stock could take a year or longer to play out. The call options in today's heavy volume expire in two days.

In other words, this is likely more of a speculative play for investors to follow. Investors who want to use call options should buy in-the-money (ITM) calls for a much longer expiry period - for example, up to a year or longer.

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.