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Babcock International Group (LSE: BAB) is less-well-known among the wider investment community than several other FTSE 100 defence stocks. Rolls-Royce (LSE: RR) springs to mind, and to a lesser degree BAE Systems (LSE: BA).
However, in my experience, lesser-known firms can offer bigger returns as their more famous peers’ valuations continue to rise. This experience includes several years as a senior investment bank trader and around 35 years as a private investor.
How the valuations stack up
A comparison of the current valuations of these three stocks using the discounted cash flow (DCF) method highlights this point. This type of analysis identifies where any firm’s stock price should be, as derived from cash flow forecasts for the underlying business.
Babcock’s DCF shows its shares are 55% undervalued at their present price of £10.58. Therefore, their fair value is £23.51.
BAE Systems’ DCF highlights its shares are 9% undervalued at £19.32. So, their fair value is £21.23.
And Rolls-Royce’s DCF underlines that its shares are 11% undervalued at their current £10.02 price. Therefore, their fair value is £11.26.
Price versus value
Babcock’s fiscal-year 2025 annual results looked so good to the markets that its share price hit an 11-year high. However, just because it did this does not affect whether there is value left in the shares.
A stock’s price and its value are not the same thing. Price is whatever the market will pay for a share at any given time. Value is what the stock is worth, based on the underlying fundamentals of the business.
It is these that are reflected in the DCF model, which is why I believe it is the optimal means to assess share values.
What were the results?
The 2025 release saw Babcock’s revenue rising 10% year on year to £4.8313bn. Over the same period, its underlying operating profit jumped 53% to £362.9m. Revenue is all income made by a firm, while profit is what is left after expenses have been deducted.
The year featured multiple major contract awards, including a £1bn five-year British Army strategic support partner contract extension. Another was a £240m missile tube assembly contract for the US ‘Columbia Class’ submarines programme. And in the aviation sector, it secured a 12-year contract with Airbus to support 48 French defence and security EC145 helicopters.
For 2026, the firm forecasts its medium-term 8% underlying operating margin target to be achieved (over a year early). It also expects to complete a £200m share buyback over the same period, and these tend to support share price gains.
A risk here is a failure in any of its key products that could damage its reputation and prove costly to fix.
That said, analysts forecast the firm’s earnings will increase by 9.2% every year to the end of fiscal-year 2028. And it is growth here that ultimately powers any firm’s share price higher over time.
My investment view
I have shares in BAE Systems and Rolls-Royce, and I am happy with these. I think they too will benefit from strong earnings growth in the years to come.
Given these holdings, adding another stock in the sector would unbalance the risk-reward profile of my portfolio.
That said, for investors without this issue I strongly believe Babcock is well worth considering.
