Image source: Getty Images
The share price of defence powerhouse BAE Systems (LSE: BA.) has experienced a sharp fall recently. Since early October, it has declined around 20%.
Should investors consider buying the dip? Let’s discuss.
Favourable backdrop for defence companies
While the heat may have come out of BAE System’s share price recently, the backdrop for the defence company still looks very favourable, in my view.
For a start, geopolitical risk remains high. Currently, there are multiple wars taking place across the world – and a lot of tension between certain countries – so no government can afford to take national security lightly.
Additionally, NATO countries recently committed to increasing their defence budgets to 5% of GDP from 2% by 2035. That’s a significant increase and it’s likely to provide a major boost for defence companies in the years ahead.
Looking at City analysts’ estimates, BAE Systems is expected to generate solid top- and bottom-line growth in the medium term as a result of this backdrop. Next year, revenue is expected to rise about 7% to £32.7bn while earnings per share (EPS) are expected to climb around 12% to 84.3p.
A reasonable valuation today
Turning to the company’s valuation, it’s looking relatively attractive after the recent share price weakness. Taking that EPS forecast above, we get a forward-looking price-to-earnings (P/E) ratio of 19.3.
For a company at the heart of the global defence expansion (offering a range of products including fighter jets, warships, submarines, combat vehicles, air defence systems, and munitions), I think that’s reasonable. Note that the price-to-earnings-to-growth (PEG) ratio is only 1.6 – that’s relatively low.
One other valuation metric that’s worth highlighting is the free cash flow yield. This is now over 5% on a trailing basis, which signals that there could be some value on offer.
It’s worth pointing out that the average analyst price target for BAE Systems is 2,074p at present. That’s almost 30% above the current share price so analysts clearly see potential for strong share price gains in the medium term.
The dividend yield is only around 2.2% though. So, there’s not much income on offer here.
The risks with defence stocks
In terms of risks, the main one is a sudden end to the geopolitical conflict taking place today. Not only could this lower demand for BAE Systems’ products but it could also negatively impact sentiment towards defence shares.
Competition from rivals such as Lockheed Martin and Northrop Grumman is also worth mentioning. For the stock to do well, BAE Systems will have to continue winning major government defence contracts.
My view on BAE Systems
Overall, I see the stock as attractive at current levels. In my view, it’s worth considering today.
That said, it’s not the only opportunity I see in the market at present. Right now, there are a lot of stocks that appear to have significant potential.
