BAE Systems’ (LSE: BA) share price is up 42% from its 6 January 12-month traded low of £11.27.
Some investors might think the stock cannot rise much further and ignore it. Others may believe they must buy it as the bullish momentum will surely continue.
I know neither approach is useful in optimising long-term investment returns from my years as a senior investment bank trader.
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Instead, I focus on two things only in a growth stock. The first is how much value remains in it and the second is its earnings growth potential.
How does the stock’s valuation look?
I always begin a share price assessment by comparing its key valuations with its peers.
BAE Systems’ price-to-earnings ratio of 25.6 is bottom of its competitor group, which averages 34.6. This comprises L3 Harris Technologies at 26.6, Rolls-Royce at 27.1, RTX at 37.8, and TransDigm at 46.8. So, it is very undervalued on this measure.
The same is true of its 1.9 price-to-sales ratio compared to the 4.3 average of its peers.
Having established a baseline undervaluation, I then look at where a stock’s price should be, based on cash flow forecasts.
The resultant discounted cash flow analysis shows BAE Systems’ is 24% undervalued at its current price of £15.99. Therefore, its fair value is £21.04, although it may go lower or higher than that.
What’s the share’s earnings growth potential?
A stock’s earnings growth powers both its share price and dividend over time. In BAE Systems’ case, analysts forecast its earnings will increase 8.4% each year to the end of 2028.
I think the main risk to this is a major malfunction in any of its key products and systems. This could be costly to fix and might damage its reputation.
That said, its 2024 results showed earnings jumped 14% year on year to £3.015bn. Sales rose the same level to £28.335bn, while profit increased 4% to £2.685bn.
Moreover, its order backlog surged 11% to a record £77.8bn, including multiple landmark deal announcements. January, for example, saw it awarded a £285m contract to upgrade the Ministry of Defence’s Royal Navy combat systems. And December brought news of a $2.5bn (£1.92bn) deal with Sweden and Denmark for new combat vehicles.
A game-changing vote in Germany?
US President Donald Trump said early in his new term that he wants European NATO members to spend 5% of their gross domestic product on defence.
Last month, his Defense Secretary told them the US’s 80-year-long defensive umbrella for Europe should not be taken for granted.
In response, 19 March saw Germany vote to exempt defence spending from its strict federal debt rules. This will free up theoretically unlimited billions of euros for spending by Germany. This will also carry across to the planned €800bn (£670bn) defence fund announced on 4 March by the European Commission.
As Europe’s biggest defence contractor and the world’s seventh -argest, BAE Systems should benefit enormously from this.
Will I buy more of the stock?
Given BAE Systems’ earnings growth potential and undervaluation, I was going to buy more on the stock shortly anyway.
The ongoing momentous change in European defence strategy further confirms to me that I am right to do so.
