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Play The Percentages With BAE Systems plc

The forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.

However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).

EPS spread Bull extreme P/E Consensus P/E Bear extreme P/E
Narrow 10% (+ and – 5%) 13.3 14.0 14.7
Average 40% (+ and – 20%) 11.7 14.0 17.5
Wide 100% (+ and – 50%) 9.3 14.0 28.0

In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the consensus 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!

BAE Systems

Today, I’m analysing Footsie defence and aerospace giant BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US), the data for which is summarised in the table below.

Share price 415p Forecast EPS +/- consensus P/E
Consensus 39.6p n/a 10.5
Bull extreme 47.5p +20% 8.7
Bear extreme 34.2p -14% 12.1

As you can see, the most bullish EPS forecast is 20% higher than the consensus, and the most bearish is 14% lower. BAE’s 34% spread is narrower than the 40% spread of the average blue-chip company, but wider than that of sector peer Rolls-Royce (27%).

In a first-quarter update released earlier this month, BAE said:

  • spending reductions announced in the US defence budget were much as management had predicted, pointing to “a more predictable outlook than we have seen in recent years”;
  • the UK business continues to benefit from “long-term, stable contracts in the maritime and military air sectors”;
  • £9.3bn of international business won last year “provides good visibility and performance in our international activities”.

‘Predictable’, ‘stable’ and ‘good visibility’ are the key clues as to why analysts’ EPS forecasts fall within a narrow range relative to the average blue-chip company — albeit the City experts see even better visibility at Rolls-Royce.

BAE and Rolls-Royce diverge more significantly in terms of investor sentiment. While the market wasn’t enamoured of Rolls-Royce’s 2014 outlook for “a pause in our revenue and profit growth”, the consensus price-to-earnings (P/E) forecast remains at a premium to the FTSE 100 long-term average of 14.

By contrast, BAE, which expects 2014 earnings to fall by “approximately 5% to 10% compared to 2013”, currently trades on a consensus forecast P/E of just 10.5. The bull extreme forecast puts the shares deep in value territory on a P/E of 8.7, while even on the most bearish earnings estimate the shares trade on a below-average P/E of 12.1.

As such, I reckon the market’s focus on the near-term headwinds facing BAE is providing a decent opportunity for long-term investors.

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G A Chester does not own any shares mentioned in this article.