The FTSE 250’s Chemring Group (LSE: CHG) provides advanced technology products and services to the aerospace, defence and security markets.
Given escalating security tensions in the Middle East, Europe, and Asia, I believe it looks set for continued strong earnings growth.
And this is ultimately what drives a firm’s share price (and dividend) higher over time.
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A bulging order book
Chemring’s 17 October trading update for Q3 showed orders rising 5.6% in the year to date to £638m. Its total order book to that point stood at £1.1bn – up 27% from Q3 2023.
A week earlier on 10 October, the Norwegian government announced a feasibility study for a new military explosives production facility in partnership with subsidiary Chemring Nobel. If approved it could significantly boost the group’s explosive materials supply business.
Aside from this, Chemring’s major businesses are Sensors & Information, and Countermeasures & Energetics.
The former includes chemical and biological threat detection, improvised explosive device detection, and a full range of electronic warfare capabilities.
The latter comprises advanced countermeasures for protecting air and sea platforms against the growing threat of guided missiles. Aside from its extensive military client base here, it has civilian customers including NASA and SpaceX.
A principal risk for Chemring is any major failure in one of its products. This could be expensive to remedy and could damage its reputation.
That said, consensus analysts’ estimates are that its earnings will grow by a stunning 23.1% each year to end-2026.
Are the shares undervalued?
My starting point in determining this is to look at key stock pricing measurements, beginning with the price-to-earnings ratio (P/E). On this, Chemring currently trades at 32.5 compared to an average of 37 for its main competitors. So it is cheap on this basis.
The same is true of another major measure I use – the price-to-book ratio (P/B). Chemring presently trades on this at 2.9 against its competitors’ average of 3.7.
To nail down what this means in cash terms, I ran a discounted cash flow (DCF) analysis. This shows Chemring shares to be 45% undervalued at their current share price of £3.71.
Therefore, a fair value for the stock is £6.75. It may go lower or higher than this, of course, given the vagaries of the market. However, it underlines to me how much of a bargain the shares look.
Will I buy the stock?
There are two reasons why the stock is not for me, despite my view that it could be the next big thing in the defence sector.
I have owned another stock in the same sector (BAE Systems) for years, bought at a much lower price. Having two defence stocks right now would unbalance the risk/reward profile of my overall portfolio.
Also, since I turned 50, I have mainly focused on shares generating yields of over 7%. I aim to increasingly live off these while reducing my working commitments.
However, I think it could be a suitable choice to consider for someone earlier in their investing journey, such as my son.
For him, Chemring offers exceptional earnings growth prospects in the coming years. This should in turn drive the share price higher. It should also power the yield up over time.
