Does BAE Systems plc Pass My Triple Yield Test?

BAe Systems Hawk 102D

Like most private investors, I drip feed money from my earnings into my investment account each month. To stay fully invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE 100 is up 68% on its March 2009 low, and the wider market is no longer cheap — it’s getting harder to find shares that meet my criteria for affordability.

In this article, I’m going to run my investing eye over BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US), to see if it might fit the bill.

The triple yield test

Today’s low cash saving and government bond rates mean that shares have become some of the most attractive income-bearing investments available.

To gauge the affordability of a share for my income portfolio, I like to look at three key trailing yield figures –the dividend, earnings and free cash flow yields. I call this my triple yield test:

BAE Systems Value
Current share price 422p
Dividend yield 4.7%
Earnings yield 8.9%
Free cash flow yield 3.5%
FTSE 100 average dividend yield 3.0%
FTSE 100 earnings yield 6.0%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.7%

A share’s earnings yield is simply the inverse of its P/E ratio, and BAE’s 8.9% earnings yield highlights the firm’s modest P/E of 11. The defence giant’s 4.7% dividend yield confirms its credentials as an attractively-priced income stock.

Although BAE’s free cash flow yield has dropped below its dividend yield over the last year, I’m not too concerned about this, as I believe the cause is a deferred payment for several Typhoon aircraft delivered to Saudi Arabia under the Salam agreement, which should eventually be resolved.

Is BAE a buy?

BAE’s share price has risen by 46% since the start of 2012, hammering the FTSE, which only gained 15% during the same period.

The fact that BAE shares still look reasonably priced, on a 2013 prospective P/E of 9.8, highlights the uncertainty felt by the market about the firm’s ability to generate growth and reduce its dependency on the UK/US.

Analysts are expecting BAE’s earnings per share to remain flat in 2014, and while BAE signed £5bn of non-UK/US orders during the first nine months of 2013, this is small beer in the context of the firm’s £43bn order book.

However, I see BAE’s UK/US dependency as a risk worth taking, because I expect both countries to remain big defence spenders throughout my lifetime. In my view, BAE’s shares are cheap enough at the moment to offset any realistic downside risk from lost contracts or spending cuts, so I rate BAE as a buy.

Where next for BAE's dividend?

BAE shares offer a prospective yield of 4.8%, and analysts expect the firm's payout to keep pace with inflation over the next year or two.

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> Roland owns shares in BAE Systems.