BAE Systems’ (LSE: BA.) share price has fallen sharply from its 12 November one-year traded high of £14.15. So sharply in fact that it is near to its 10 January 12-month traded low of £11.38.
In my experience as a former investment bank trader and now private investor, this might signal a serious bargain to be had.
For me, it all depends on why the stock has fallen, what the firm’s earnings outlook is, and how technically undervalued the shares are.
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What’s behind the share price fall?
I think the initial reason for the fall was profit-taking after the Q3 trading statement released on 12 November. However, there was nothing wrong with the numbers, in my view. They reiterated the upgraded guidance previously given in the 1 August H1 results. This included year-on-year sales growth of 12%-14% and underlying earnings before interest and taxes growth of 12%-14%.
Consequently, I think the beginning of the sell-off was just profit-taking after the stock’s huge rise since 24 February 2022. Specifically, it opened trading at just £6.01 on that morning when Russia invaded Ukraine.
Another reason for the stock’s decline is the markets’ view on global security under US President-elect Donald Trump, I think.
He has said he will end the war in Ukraine in a day, after he takes office on 20 January. Meanwhile, Israeli initiatives against Iran’s proxies appear to have reduced ongoing hostilities in the Middle East.
Will these factors last?
My view is that even if Trump engineers some sort of peace in Ukraine and the Middle East, the global security threat will not diminish.
Any land gains given to Russia as part of a Ukraine ceasefire will stoke its territorial ambitions in Europe, in my view.
And Trump has told European NATO countries that they must spend 2%+ of their gross domestic product on defence. It has been estimated that €1.8trn (£1.5trn) is required to compensate for 30 years of underinvestment.
What’s the firm’s earnings outlook?
As the largest defence contractor in Europe and the seventh largest in the world, BAE Systems should benefit from this spending.
A risk to its earnings is that the world becomes an enduringly peaceful place, as many of us wish it will. Another is any major failure in one of its core products, which would prove costly to fix.
However, consensus analysts’ estimates are that its earnings will increase by 8% annually this year and next. It is this growth that drives a company’s share price and dividend over time.
Are the shares undervalued?
BAE Systems’ shares are bottom of their competitor group on the key price-to-earnings valuation measure – at just 18.6. Rolls-Royce is at 20.7, RTX at 32.5, L3Harris Technologies at 32.8, and TransDigm at 48.6, giving an average of 33.7. So, it is very cheap on this basis.
To put all this into share price terms, I ran a discounted cash flow analysis. Using other analysts’ figures and my own, this shows the stock is 24% undervalued at its current £11.45 price.
Therefore, the fair value for the shares is technically £15.07, although they may go lower or higher due to market vagaries.
This undervaluation and its strong earnings growth prospects make the stock an unmissable bargain for me. I will be buying more very shortly.
