It is in FTSE 250 that I look for the next big firms in each business sector. Successfully identifying them at this point allows a future superstar to be bought at a bargain basement price.
Two stocks that have caught my eye in the defence sector are Chemring Group (LSE: CHG) and QinetiQ Group (LSE: QQ).
Both have excellent growth prospects, in my view. And both are better value currently than the big FTSE 100 defence firm BAE Systems (LSE: BA) right now.
How the valuations compare
On the key price-to-book ratio (P/B) measure of stock valuation, BAE Systems trades at 3.5, Chemring at 3, and QinetiQ at 2.8.
The peer group average P/B is 3.5, so both Chemring and QinetiQ look cheap on this basis.
To ascertain how cheap in cash terms, I ran a discounted cash flow (DCF) analysis using other analysts’ figures and my own.
This shows Chemring to be 65% undervalued at its current share price of £3.81. QinetiQ is undervalued by 50% on its present £4.52 share price.
Therefore, the fair value of Chemring shares is £10.89, and of QinetiQ’s £9.04.
Incidentally, BAE Systems shares are also underpriced — by 22% on the DCF measure, implying a fair price of £16.67.
How growth looks for each
A key risk for all three companies is that the world suddenly becomes a much safer place, much as we would all like that.
Another risk for Chemring would be delays in meeting its extensive order book, which might damage its reputation over time. For QinetiQ, a major fault appearing in a key product would be expensive in time and money to fix.
And any failure to correctly manage its foreign exchange exposures could prove costly for BAE Systems, given its huge international order book.
That said, share prices and dividends are driven by sustained increases in earnings over time.
Consensus analysts’ expectations are that Chemring’s earnings will grow 23.47% every year to the end of 2026. QinetiQ’s are projected to increase 10.47% a year to the same point.
And there still looks plenty of growth left in BAE Systems – 7.34% annually by end-2026.
Will I buy the stocks?
I have built up my holding in BAE Systems over many years at an average price much lower than it is now. So, I am very happy with that position.
Aside from this firm, and a handful of other stocks, I am now focusing on high-yield shares. Aged over 50 now, I want to continue to reduce my working commitments and live off dividend income.
I think that the yields of Chemring and QinetiQ – each 1.8% — will increase in line with their business growth. However, I do not believe either will rise to over my minimum 7%+ requirement within the next five years. That is too long for me to wait at my stage in the investment cycle.
That said, if I were even 10 years younger, I would be happy to buy either of these two companies. But right now, Chemring has more value in the price, so if I had to make a choice today it would be that.
