Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up: growth in earnings and an upwards P/E rerating.
Highly successful fund manager Peter Lynch classified steady growers as "Stalwarts," which he typically traded for 20%-50% share-price gains. But, whether buying for gains like that or holding for the longer term, we need to know if reliable earnings growth can continue, and whether the shares are cheap.
Seeking durable growth
Not all companies achieve stable growth, as you can see by the aggregate performance of those in London's premier FTSE 100 index (UKX), where the compound annual earnings growth rate has been just 0.7% over the last five years:
Year to June
FTSE 100 index
Aggregate earnings per share
Consistent, cash-flow-backed growth in profits is a promising characteristic in today's markets so, for this series, I'm examining firms with annual earnings growth between 4% and 20%.
One contender is BAE Systems (ISE: BA.L) , which is one of the world's biggest weapons and aviation groups. This table summarizes the company's recent financial record:
Adjusted earnings per share
So, earnings have grown at an equivalent 10.9% compound annual growth rate putting BAE Systems in the "Stalwart" category.
The firm describes itself as a global defense, aerospace, and security company employing around 93,500 people worldwide. Its products and services include air, land, and naval forces requirements such as advanced electronics, security, information technology and support services. In effect, the company supplies many of the world's fighter planes, radar systems, attack missiles, warships, and munitions.
BAE analyzes its revenue by reporting segment, with roughly 32% coming from platforms and services U.K. division, 28% from the U.S. division, 20% from the international division, 13% from electronic systems, and 7% from cyber and intelligence.
Thanks to tightening government budgets, BAE has been operating in a difficult trading environment in its largest U.S. and U.K. markets for some time, according to the directors. However, the company is engaged in strategic actions it believes are necessary to sustain and position the business for the future. It seems that future earnings growth isn't going to arrive without a fight!
BAE Systems' earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and if the shares offer good value:
revenue and cash flow have declined despite growth in adjusted earnings. (1/5)
net gearing of around 33% plus a large pension deficit. (3/5)
good recent trading and a cautiously positive outlook. (4/5)
free cash seems small: this ratio around 60. (1/5)
historically about eight, so below earnings growth rate. (3/5)
Overall, I score BAE Systems 12 out of 25, which makes me cautious, although it's still possible for future earnings growth to outpace that of the wider FTSE 100. Considering the firm's growth predictions, I think the shares fairly price the company.
Although growth in adjusted earnings has held, revenue and cash flow has declined and the company has a fair slug of debt, particularly when including the pension liabilities. That said, recent trading has been good and the trading environment has stabilized according to the directors.
Right now, forecast earnings growth is just 1% for 2013, and the forward P/E ratio is around eight with the shares at 341 pence. Considering that and the other factors analyzed in this article, I think that BAE's shares could be attractive as a cyclical investment, but I'm happy to keep the firm on My Watchlist for now.
BAE Systems is one of several once-steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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The article Is FTSE 100 Stalwart BAE Systems a Good Value? originally appeared on Fool.com.
Kevin Godbold does not own any shares mentioned in this article.The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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