BAE Systems’ (LSE: BA) share price is down 15% from its 12 November one-year traded high of £14.15.
I think this drop partly reflects investors taking profits after a 101% rise in price from the day Russia invaded Ukraine.
In my view, the other part assumes a decline in the global security threat during Donald Trump’s second presidential term.
Looking ahead, most of the profit-taking now appears to be in the price. And the assumption that the world is set to become significantly more peaceful looks wrong to me.
A more peaceful world?
The Israel-Hamas ceasefire does not necessarily mean Iran will let Israeli attacks against its proxies go unanswered for long. And the removal of Syria’s longstanding leader may bring about another regional and global threat from Islamic extremism.
Trump promised to bring an end to the Russia-Ukraine War in 24 hours, but it is still rumbling on. Even if a ceasefire is reached there, the US and its NATO partners remain on heightened security alert.
In his first presidency, Trump told European NATO countries they must spend 2%+ of their gross domestic product on defence. It is estimated that €1.8trn (£1.5trn) is required to compensate for 30 years of underinvestment to reach that level.
Much as we may hate war, BAE Systems should benefit from this spending as the largest defence contractor in Europe and the seventh largest in the world.
That said, Trump has since told European officials he wants this to rise to 5%, according to a December Financial Times report.
So do the shares look a bargain?
Given this backdrop, I am amazed to see BAE Systems is currently trading at a price-to-earnings (P/E) ratio of just 19.6. This is bottom of its group of competitors, which average a P/E of 32.1.
These peers comprise Rolls-Royce at 21.8, L3Harris Technologies at 26.4, RTX at 36 and TransDigm at 44. So BAE Systems looks a huge bargain on this measure.
The same is true of its price-to-sales (P/S) ratio of only 1.5. This is again bottom of this group of peers, with a 4.1 P/S average.
I ran a discounted cash flow valuation to see what this all means for the share price. Using other analysts’ figures and my own, this shows BAE Systems’ shares are 29% undervalued at their present £12.08 price.
Of course, market fluctuations may push them lower or higher than this. But it reiterates to me how much of a bargain they now look.
Does the core business support this view?
Earnings growth ultimately powers a firm’s share price (and dividend) over time. A risk to this for BAE Systems is a global reduction in defence spending. Another is any major fault in one of its key products that could be costly to fix.
However, analysts forecast that its earnings will grow each year by 8.3% to the end of 2027.
In this context, 13 December saw it announce a new joint venture with Italy’s Leonardo and Japan’s JAIEC to deliver next-generation combat aircraft.
And on 27 January it was awarded a £285m contract to upgrade the Ministry of Defence’s Royal Navy combat systems.
Given all this, BAE Systems’ shares look an unmissable bargain to me, and I will be adding to my holding very soon.
