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Constellation Brands (STZ) reported last week that it made higher-than-expected free cash flow (FCF) last year. Despite raising the dividend by just 1% (lower than expected), investors can make more income by shorting out-of-the-money STZ put options.

STZ is at $185.30 in midday trading on Tuesday, April 15. This is up from a low of $170.96 on April 9, just before its April 9 earnings release for the year ending Feb. 28.

As a result of its FCF projections, STZ stock could be worth at least $195 or +5% more. I explained this in my April 1 Barchart article, “Constellation Brands Could Hike Its Dividend Next Week - STZ Stock Looks Very Cheap.”

Moreover, shorting one-month out put options, with their high premiums, will give investors a good buy-in target price and extra income. This article will delve into these points.

Strong Free Cash Flow (FCF) and Margins

On April 9, Constellation Brands, which makes Corona and Modelo beers, generated $1.9 billion in free cash flow (FCF) last year. That was much higher than its prior guidance of between $1.6 billion and $1.8 billion. That was 28% higher than last year.

Moreover, this FCF  represented 18.6% of its $10.209 billion in sales, much higher than expected. For example, in my prior Barchart article, I estimated that its FCF margin would be 16.7% of $10.17 billion in estimated sales.

In addition, the company provided new FCF guidance for the coming year. They estimate that FCF will be between $1.5 billion - $1.6 billion (after divestitures). Given analysts' estimates, here is what that works out to:

  $1.55b FCF (midpoint of guidance range) / $9.72 billion sales (i.e., 4.7% decline) = 15.95%

Let's assume Constellation Brands is being conservative, and round this off at 16.5%. That is about 200 basis points lower than last year. 

That could be why the company hiked its dividend per share (DPS) by just 1% from $4.04 to $4.08. How will these lower-than-expected results affect the valuation of STZ stock?

Valuing STZ Stock 

One way to value STZ is to assume that the market gives the stock about a 4.7% free cash flow yield. Here is how this is calculated.

Right now, the dividend yield is about 2.2% (i.e., $4.08 DPS/$185.30). That is about 44% of a 5% FCF yield metric. 

For example, the forward dividend will cost about 47% of the forward FCF.

  $4.08 DPS x 179.9 million shares = $734 million

  $734m dividend cost / $1,550 million est. FCF = 0.47

The point is that the dividend is covered more than 2x from free cash flow, so the market will likely value the stock slightly more than twice the dividend yield:

  1/0.47 = 2.13x, so 

  2.13x 2.2% = 4.686% FCF yield metric, i.e., 4.7%

As a result, let's assume that the market will eventually value Constellation's estimated FCF with a 4.7% yield:

  $1.6 billion FCF / 0.04686 = $34 billion mkt cap

That means the market will give the stock a $33 billion market cap valuation. This is about 2.1% higher than today's market value of $33.3 billion. It implies a price target of $189.19 (i.e., 1.021 x $185.30).

However, I suspect Constellation's guidance for $1.6 billion upper-end FCF is too low. Last year it exceeded this forecast, and it could again this year. Moreover, the market is likely to increase the valuation to at least 4.5% (i.e., 22x FCF)

  $1.7b est. FCF / 0.045 = $37.77b mkt cap

That is 13.5% higher than today's market. This implies a target price of $210.32 per share (i.e., 1.135 x $185.30). Averaging these two forecasts results in a modified price target of $199.76, or +7.8% upside from today.

The bottom line is that STZ could be undervalued, especially if its FCF results this year ending Feb. 2026 come in higher than forecast.

The problem with this analysis is that there is no guarantee this will happen. One way to make money now on STZ stock is to sell short out-of-the-money (OTM) puts in nearby expiry periods.

Shorting OTM Puts

I discussed this in my April 1 Barchart article. The April 25 expiration $175.00 strike puts were trading for $4.55 (midpoint) per contract. That provided a short seller of these puts a huge 2.6% yield (i.e., $4.55/175.00) for a 24-day to expiry (DTE) investment. Note that the strike was 4.8% below the trading price and had a 31% delta ratio, implying that there was low risk of assignment.

Today, that strike price premium is just 68 cents at the midpoint. In other words, the investor who shorted these puts has made $387 on the $17,500 investment, or 2.21%.

It may make sense to roll this trade over and extend it to a later period. For example, the May 16 expiry period shows that the $180 strike price put option has a $3.95 midpoint premium. That provides a short-seller of these puts can make an immediate yield of 2.194% (i.e., $3.95/180.00).

There is a slightly higher risk since this strike price is only 3% below today's trading price, and the delta ratio is higher at 34%. The point is that if an investor wants to set a lower buy-in target price (with a higher chance of being assigned to buy 100 shares per put contract shorted), they can do the $180 short-put play.

The advantage here is that even if the account is assigned to buy shares (if STZ falls to $180 or lower on or before May 16), the investor's breakeven is lower:

  $180.00 - $3.95 = $176.05

That is about 5% below today's trading price, allowing an investor to set a lower buy-in price. Nevertheless, it could result in an unrealized loss if STZ falls to a lower price.

As a result, more risk-averse investors could short the $175.00 May 16 strike price for $2.55. That provides an immediate yield of 1.457% ($2.55/$175), and a lower breakeven of $172.45 (6.8% below today's price).

The bottom line is that STZ looks cheap, and one way to play this is to sell short OTM puts.

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.