The FTSE 100 is home to plenty of defence heavyweights, including BAE Systems, Rolls-Royce, and Babcock International. But none of these is currently as deeply undervalued as the often-overlooked Melrose Industries (LSE: MRO), by my reckoning.
Parent of tier-one defence and aerospace supplier GKN Aerospace, Melrose is a critical supplier to the global defence ecosystem. This provides it with strong structural demand, long‑term revenue visibility, robust pricing power, and clear geopolitical support.
But the market is still pricing it as the old, lower‑margin business it was before it refocused on aerospace, with a major defence slant.
So, how much can investors make from that price-to-valuation gap now?
How’s its valuation compared to peers?
A good starting point to assess Melrose’s valuation is a comparison with its direct competitors.
On the key price-to-earnings measure, its ratio of 17 is the second lowest of these firms, which average 30.3. The companies are Safran at 16.2, BAE Systems at 31.9, GE Aerospace at 34.5, and RTX at 38.6. So, it is deeply undervalued on this basis.
The same is true of its price-to-sales ratio of 1.7 — bottom of its peer group, which averages 3.9. And it also looks a bargain on its 2.2 price-to-book ratio compared to its competitors’ average of 8.3.
What’s it really worth?
Discounted cash flow (DCF) analysis identifies where a stock should trade by projecting future cash flows for the underlying business and ‘discounting’ them back to today.
Analysts’ DCF modelling varies — some more bullish than mine, others more cautious — depending on the variables used. However, based on my DCF assumptions — including an 8.5% discount rate — Melrose shares are 54% undervalued at their current £5.27 price. So the fair value is around £11.46, according to my model.
Asset prices can trade towards their fair value in the long run. If those DCF assumptions hold, this suggests a potentially superb buying opportunity to consider today.
What’ll drive earnings higher from here?
Its 2025 annual results saw adjusted operating profit soar 20% year on year to £647m. This highlighted that the shift towards higher‑margin aerospace programmes is already boosting profitability. With defence‑linked engine components continuing to scale, that margin expansion looks set to continue.
Revenue in its key Engines division jumped 15% to £1.63bn, underlining strong long‑term demand across key platforms, including the F‑35 and next‑generation fighter engine families. It gives the business a multi‑year pathway of volume growth that should support rising earnings ahead.
And free cash flow saw a £199m improvement to a £125m inflow. The turnaround demonstrated how restructuring costs are falling away and operational efficiencies are bedding in. Management expects this to accelerate as the group targets stronger cash conversion through 2028/29.
A risk here is any major failure in one of its key products that could be expensive to remedy. Another is any supply-chain delays that could restrain production momentum.
Even so, these growth factors show a business with rising profitability, improving cash generation, and a clearer strategic runway than the market is currently pricing in.
My investment view
I already hold shares in BAE Systems and Rolls-Royce, so owning another in the sector would unsettle the risk-reward balance of my portfolio.
However, for investors without this problem, I believe Melrose looks a great business to consider, at a bargain price.
