We've already doubled our money on this defence company, but it's more attractive than ever
Given that the stock currently trades on a price-to-earnings (P/E) ratio of 19.1, versus 12.5 at the time of our 'buy' recommendation, many investors may naturally assume that it is now a far less appealing purchase than it was nearly eight years ago. Such investors would, furthermore, be likely to baulk at the idea that the stock is in fact a far more attractive purchase today than it was all the way back in 2017.
Indeed, some stock market investors continually struggle to separate 'price' from 'value'. Just because a stock is cheap does not necessarily mean it is a worthwhile purchase. Lacklustre financial performance or weak financial standing, for example, can mean its earnings multiple moves ever lower. Conversely, expensive stocks can offer excellent value for money if they have strong profit growth potential and solid fundamentals.
In QinetiQ's case, this column firmly believes that it is far easier to justify a P/E ratio of 19.1 today than an earnings multiple of 12.5 at the time of our original tip in 2017. For example, in the two financial years following our initial recommendation, the stock posted annualised earnings growth of just 4pc amid a rather humdrum performance from the defence industry. Therefore, it was only deserving of what was essentially a modest market valuation.
In the current geopolitical climate, where conflict in Europe and the Middle East is prompting rapid increases in military spending across developed economies, the company is expected to produce annualised earnings per share growth of 17pc over the next two years. This means that its P/E ratio could realistically move substantially higher as investors continue to factor in an extended period of elevated geopolitical risks and rising military spending.
Furthermore, the full impact of the current era of monetary policy easing is yet to be felt due to the existence of time lags. With further interest rate cuts likely to be ahead, the pace of GDP growth may improve, thereby providing a further catalyst for defence spending due to it being expressed as a percentage of economic output.
Even if QinetiQ does not deliver any further increase in its earnings multiple, a 17pc annualised capital gain, derived from its prospective earnings growth rate, would be highly satisfactory. With the company's latest trading update showing that its financial performance during the first quarter of the financial year was in line with expectations, it appears to be delivering on its potential.
Encouragingly, the firm reported that its cost savings initiative is on track. This should lead to a 140 basis point increase in the company's operating profit margin, which signals an improving competitive position, so that it amounts to 11pc this year. It is also making progress in restructuring its US operations, while a record order backlog of £5bn suggests the firm has an upbeat long-term outlook.
With net gearing of just 21pc and net interest cover of around 13 last year, the company has a solid financial position through which to reinvest for long-term growth. A sound balance sheet further suggests that it is worthy of a premium valuation relative to other mid-cap stocks.
Although two thirds of the company's sales are generated within the UK at a time when some of its sector peers are more geographically diverse, Questor is upbeat about the economy's performance. Sticky inflation is widely expected to come to an end over the medium term, with the Bank of England having licence to implement a looser monetary policy in the meantime.
Of course, this does not mean that QinetiQ's share price is immune to heightened volatility in the short run as a global trade war continues to play out. However, given the increasingly positive prospects for the defence industry, as well as the company's sound fundamentals, it represents a highly appealing investment opportunity for the long term.
Ticker: QQ
Share price at close: 498.4
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