The previously buoyant BAE Systems (LSE: BA) share price has tumbled 21% from its 3 October 12-month high of £20.71.
I think this has been driven by optimism for an imminent peace deal in Ukraine.
However, I believe that despite any such deal, key factors are converging that will drive the stock higher.
So, what are these and how high can it go?
NATO’s spending spree
Investing in defence stocks is not about benefitting from global insecurity in some way – quite the opposite, in fact. If anything, it is part of the process of underwriting peace through deterrence.
An old Roman phrase encapsulates the current mood of NATO countries in this regard. It is: “Si vis pacem, para bellum”, which translates as: “If you want peace, prepare for war.”
Put simply, whatever unfolds in Ukraine, the transatlantic security alliance is no longer taking any chances.
Members have pledged to raise defence budgets to 5% of their gross domestic product (GDP). Last year, it averaged 2%.
This is roughly $423bn more each year in collective non-US NATO defence spending. Currently, non-US members’ collective GDP is around $14.1trn, while US defence spending already dwarfs the rest of NATO. As Europe’s largest defence contractor and the world’s sixth-largest, BAE Systems is ideally placed to ride this huge surge in deterrence.
Embedded in NATO’s security architecture
Another key positive for BAE Systems is that it does not just sell standalone products to NATO. Its systems are integral to the alliance’s command‑and‑control, electronic warfare, and cyber resilience platforms.
This also means it is embedded in core defence programmes for decades. NATO’s submarine programmes run from 30-40 years, while BAE is lead integrator for the UK’s Dreadnought submarinesnuclear deterrent.
NATO’s fighter jet programmes span 20-30 years, and BAE Systems builds critical parts and systems for every NATO F-35 Lightning II. It also co-developed and continues to upgrade systems used by the Eurofighter Typhoon.And BAE Systems is the prime contractor for the Tempestfuture combat aircraft.
In short, the firm is locked into decades of upgrades, sustainment, and servicing.
This should provide an expanding pipeline of guaranteed revenues for the firm stretching into the 2040s at minimum.
As of the firm’s 12 November trading update, it had a record order backlog of £78.3bn. This was up around 18% year on year.
A risk to its earnings is any failure in any of its major systems. Earnings growth is the key driver for any firm’s share price over time.
However, analysts forecast its earnings will grow by 11.2% a year to end-2028 at minimum.
Are the shares undervalued?
A discounted cash flow analysis shows BAE Systems shares are 36% undervalued at their current £15.99 price.
Therefore, their ‘fair value’ is £24.98.
This method provides a ‘clean’ standalone valuation based on cash flow forecasts for the underlying business.
However, the stock also looks very undervalued on comparative measures to its competitors.
Its 1.8 price-to-sales ratio is bottom of this group, which averages 4.5. These firms comprise L3 Harris Technologies at 2.4, RTX at 2.7, Rolls-Royce at 4.5, and TransDigm at 8.6.
My investment view
Given its strong earnings growth prospects, extreme undervaluation, and beneficial business sector outlook, I will buy more of the stock very shortly.
I also think it well worth the consideration of other investors.
