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FTSE 250 defence firm Chemring Group (LSE: CHG) is down 9% from its 20 August one-year traded high of £4.24.
This could indicate that the company is fundamentally worth less than it was before.
Or it could be that the market has not factored its full value into the share price. In this event, the stock could be a huge bargain buying opportunity for investors whose portfolios it suits.
How does the global security backdrop look?
I think that irrespective of any ceasefire deal struck in the Russia-Ukraine War, NATO’s defence spending will increase dramatically.
This is likely to focus on preventing further Russian military actions against its member states.
Indeed, NATO Secretary-General Mark Rutte said in December that the security organisation needs to: “Shift to a wartime mindset.”
He added in February that average spending will have to increase to “considerably more than 3%” of members’ gross domestic product (GDP). Only 23 out of the 32 NATO members managed to reach the previous target of 2% this year.
In my view, it may well have to go even higher than 3%. US President Donald Trump made clear recently that he wants NATO members to spend 5% of their GDP on defence.
The stock’s earnings growth potential
Earnings growth ultimately drives a company’s share price and dividend over time. A risk to Chemring is any major fault in its key products. This could prove costly to fix and might damage its reputation.
However, analysts forecast the firm’s earnings will increase 18.2% each year to the end of 2027.
Its full-year 2024 results saw revenue rise 8% year on year to £510.4m, and operating profit jumped 28% to £58.1m. Profit after tax soared more than sevenfold to £39.5m.
Over the same period, its order book jumped 13% to an all-time high of £1.038bn. Since Russia invaded Ukraine in 2022, it has risen 59%.
In the results, Chemring also reiterated its previous target of achieving revenue of around £1bn by 2030.
In this context, the maker of sensors, countermeasures and information products counts big civilian firms among its customers and military ones. These include NASA and SpaceX.
In January, its Roke operation signed a £26m contract with a major US prime contractor to supply high-speed Miniature Radar Altimeters. Expanding in the US through such firms that work alongside the US government is key to Chemring’s growth strategy.
Are the shares undervalued?
My key method to determine whether a stock has value in it is the discounted cash flow (DCF) model. This shows where a firm’s stock price should be, based on future cash flow forecasts for it.
Using other analysts’ figures and my own, the DCF for Chemring shows its shares are 63% undervalued at their current £3.85.
Therefore, the fair value for the stock is technically £10.40.
It may be pushed lower or higher than this due to the unpredictability of the market. However, it underlines to me what a bargain the shares look right now.
Will I buy the shares?
I would buy it but I already have shares in defence stock BAE Systems. To add another share in the same sector would unbalance the risk-reward balance of my portfolio.
That said, I believe Chemring shares are worth considering today for their high earnings growth potential.
