Its been a topsy-turvy year for investors in BAE (LSE: BA). Indeed, the defence company saw its share price decline in the early part of the year by a profit warning before gradually climbing back to the same level at which it started the year. Overall, its performance in 2014 has been in line with the FTSE 100, but the interim has been a far more volatile experience for investors in BAE than for the wider index. However, 2015 could be a much better year for the company and it could see its share price rise by 20% over the medium term. Heres why.
Certainly, shares in BAE seem to offer great value for money right now. While the FTSE 100s price to earnings (P/E) ratio is 13.7, BAE currently trades on a P/E of just 11.8. Furthermore, the company has a strong long-term future, with the defence industry continuing to be highly lucrative. Indeed, BAE is forecast to grow its bottom line by 4% next year, which is in line with the expected growth rate of the wider market. This may not sound so impressive, but at a time when the US is going through its sequestration (cuts to military spending), growth of 4% is remarkably strong.
Although BAE is battling a challenging market in the short run, it appears as though the company has the scope to be more generous when it comes to dividend payments. Certainly, shares are a top income play at present, with BAE yielding an impressive 4.6%. However, the company pays out just 55% of profit as a dividend which, for a mature company operating in a mature industry, seems rather low.
Of course, BAE needs to invest a sizeable minority of profit in the business so as to improve and add to its plant and machinery, as well as to conduct research and development. However, a payout ratio of the order of 65% could be feasible, since it would ensure an adequate reinvestment rate and also appeal more to investors especially those seeking income.
A payout ratio of 65% would equate to dividends per share of around 24.2p. If shares in the company were to continue to trade at a yield of 4.6% (which assumes that the market would bid up their price so as to maintain the current yield), then it would equate to a share price of 525p, which is almost 20% higher than the current price.
This appears to be a realistic target price for investors, with BAE having strong long term potential, a low valuation and the scope to benefit from an improving macroeconomic outlook that could reduce the severity of military spending cuts. As a result, BAE seems to be a strong buy right now that offers 20%+ upside over the medium term.
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Peter Stephens owns shares of BAE Systems. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.