BAE Systems (LSE: BA) shares are up 221% from their £6 opening price on 24 February 2022 – the day Russia invaded Ukraine.
This is unsurprising to me, as the firm is Europe’s largest defence contractor and the world’s seventh-largest.
I am also undeterred from adding to my existing holding of the stock at regular intervals for two other reasons.
First, the global security situation has never looked worse in my 58 years on this planet, including during the Cold War. This should benefit a leading defence contractor like BAE Systems.
And second – from a technical stock perspective – price and value are not the same thing. So a firm’s stock price can rise enormously, but there can still be huge value left in it.
Europe is on a war footing
NATO’s Secretary General Mark Rutte last December put into words what many had been thinking for some time.
He said Russian President Vladimir “Putin believes that a serious, irreconcilable struggle is unfolding for the formation of a new world order… Others share his belief, not least China”.
He concluded: “This requires us all [in NATO] to shift to a wartime mindset and turbo-charge our defence production and defence spending.”
In practical terms, this should increase the spending of European NATO members to 5% of their gross domestic product. In 2024 it averaged 2%. US President Donald Trump also expects this level. He has repeatedly suggested the US will not protect NATO allies that do not meet this spending target.
Are the shares undervalued?
Despite its share price rise, BAE Systems still looks very undervalued on the key price-to-sales ratio at just 2.2. This is second-bottom in its peer group which comprises L3Harris Technologies at 2.1, RTX at 2.3, Rolls-Royce at 3.9, and TransDigm at 9.8.
It also looks undervalued on its 29.6 price-to-earnings ratio against its peer group’s average of 36.5.
To put these into share price terms, I ran a discounted cash flow (DCF) analysis using other analysts’ figures and my own. This identifies where any firm’s stock price should be, based on future cash flow forecasts for it.
The DCF for BAE Systems shows its shares are 20% undervalued at their present £19.23 price.
Therefore, their fair value is technically £24.04.
How is the business doing?
A risk in the value of the stock is any major reduction in global insecurity, much as we would like to see that. Another is a failure of any of its key products that could adversely affect sales and its reputation.
However, BAE Systems’ 7 May trading update reiterated its 7%-9% year-on-year forecast for a rise in 2025 sales (from last year’s £28.3bn). It also highlighted an 8%-10% increase in earnings before interest and taxes from 2024’s £3bn.
On 5 June, the firm was awarded a $1.2bn (£0.89bn) contract for the US Space Force missile warning and tracking satellite system. And the day before, it was handed a $30m contract from the US Department of Defense for counter-cyber threat systems.
Will I buy more shares?
The three key themes underpinning my previous purchase of the stock remain. It is still a leading global defence contractor, the world’s security situation is worsening, and the stock looks undervalued.
Therefore, I will buy more of the shares very soon.
