Hidden (for now) in the FTSE 250, is this growth stock the next big thing in the defense sector?

THE FTSE250It is Chemring Group (LSE: CHG) provides cutting-edge technology products and services to the aerospace, defense and security markets.

Given the escalating security tensions in the Middle East, Europe and Asia, I think strong earnings growth appears to be continuing.

And that’s ultimately what drives a company’s stock price (and dividends) higher over time.

A full order book

Chemring’s October 17 trading update for the third quarter showed orders increased by 5.6% in the year to date, to £638 million. Its total order book then stood at £1.1 billion, an increase of 27% compared to the third quarter of 2023.

A week earlier, on October 10, the Norwegian government announced a feasibility study for a new military explosives production plant in partnership with its subsidiary Chemring Nobel. If approved, this project could significantly increase the group’s explosive materials supply activities.

Apart from this, Chemring’s main businesses are sensors and information, as well as countermeasures and energy.

The first includes chemical and biological threat detection, improvised explosive device detection, and a full range of electronic warfare capabilities.

The latter includes advanced countermeasures to protect air and maritime platforms against the growing threat of guided missiles. In addition to its large military customer base, it has civilian customers including NASA and SpaceX.

One of the main risks for Chemring is any major failure of one of its products. This could be costly to remedy and damage its reputation.

That said, consensus analysts estimate its earnings will grow 23.1% each year through the end of 2026.

Are stocks undervalued?

My starting point in determining this is to look at the main stock price metrics, starting with the price-to-earnings (P/E) ratio. On this score, Chemring is currently trading at 32.5 compared to an average of 37 for its main competitors. So it’s cheap on that basis.

The same goes for another major metric I use: the price-to-book (P/B) ratio. Chemring is currently trading at 2.9 compared to an average of 3.7 for its competitors.

To understand what this means in terms of cash flow, I performed a discounted cash flow (DCF) analysis. This shows that Chemring shares are 45% undervalued at their current price of £3.71.

Therefore, the fair value of the stock is £6.75. It can of course go down to a lower or higher level, taking into account the vagaries of the market. However, this shows me what a good deal the shares seem to be.

Will I buy the shares?

There are two reasons why this title doesn’t sit well with me, although I think it could be the next big thing in the defense industry.

I owned another stock in the same sector (BAE Systems) for years, bought at a much lower price. Having two defense stocks right now would unbalance the risk/reward profile of my overall portfolio.

Also, since I turned 50, I have focused mainly on stocks generating returns above 7%. My goal is to live more and more while reducing my professional commitments.

However, I think it might be an appropriate choice to consider for someone earlier in their investing journey, like my son.

Chemring offers exceptional prospects for profit growth in the years to come. This in turn should drive the stock price higher. This should also increase yield over time.