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BAE Systems‘ (LSE: BA) share price has dropped 8% from its 5 June one-year traded high of £19.98. However, this still leaves it up 206% from 14 February 2022, when Russia invaded Ukraine.
The world since then has certainly not become a more peaceful place. And NATO members are aware they have to keep boosting their defence spending to reduce the chance of war.
BAE Systems — as Europe’s largest defence contractor and the world’s seventh largest – has looked a prime beneficiary for this spending.
Has the investment rationale changed?
At the 24-25 June NATO summit, the European allies decided to spend 5% of their gross domestic product on defence. This aligns with US President Donald Trump’s view on how much they should spend, compared to 2024’s 2% average.
There also remains a global security threat from China in Asia Pacific. President Xi Jinping has ordered the military to “be ready by 2027” to invade Taiwan.
And in the Middle East, the current ceasefire between Israel and Iran looks fragile.
How does the core business look?
Given the race to boost defence spending, BAE Systems’ order book is swelling by the month. In June, the UK government released £204.6m in funding for new radar for the Royal Air Force’s Eurofighter Typhoon jets. The firm’s a key partner in this programme.
Just a few days before, it was awarded a $1.2bn (£0.89bn) contract for the US Space Force missile warning system. And just prior to that, it won a $30m contract from the US Department of Defense for counter-cyber threat systems.
BAE Systems forecasts a 7-9% year-on-year rise in sales from 2024’s £28.3bn. It also projects an 8-10% increase in earnings before interest and taxes (EBIT) from last year’s £3bn. In its full-year 2024 results, the firm’s order backlog rose 11% to £77.8bn.
A risk here is of some major fault in one of the firm’s key products. This could be expensive to fix and could also damage its reputation.
That said, consensus analysts’ forecasts are that its earnings will jump 9.5% a year to the end of 2027. And it’s growth here that ultimately powers any firm’s share price and dividends higher over time.
Are the shares going cheap?
Looking first at key stock valuation measures, BAE Systems’ 28.9 price-to-earnings ratio is undervalued against its 38.3 peers’ average. These comprise L3Harris Technologies at 29.2, Rolls-Royce at 32, RTX at 42.4, and TransDigm at 49.7.
It also looks cheap at a 2.1 price-to-sales ratio compared to its competitors’ average of 4.8.
A discounted cash flow analysis highlights where any firm’s share price should be, derived from cash flow forecasts for the underlying business. The one for BAE Systems shows it’s 19% undervalued at its current £18.42 price.
Therefore, the fair value for the shares is £22.74 – a bargain to its price now.
My view
I already have a considerable holding in BAE Systems, so am happy with that.
However, I think it’s well worth the consideration of investors, given its strong earnings growth prospects. This should drive the share price (and dividends) higher over the long term.
