The FTSE 100 contains some companies whose valuations seem oddly disconnected from their underlying strength. Melrose Industries (LSE: MRO) is one of those, in my view.
After reshaping itself into an aerospace and defence specialist, it now enjoys long‑cycle demand, high barriers to entry, and strong pricing power. Yet the market prices it as if it were the old, sprawling conglomerate.
So what sort of gap is there between its current price and its true worth?
Why is choosing the right valuation method critical?
The price of a share is simply the outcome of short-term trading. But its true worth (‘fair value’) is rooted in the long-term fundamentals of the business behind it.
For long-term investors, that gap is critical to maximising lasting profits. That is because history shows that prices usually gravitate towards fair value over time.
That said, nearly all the major valuation methods used by non-professional investors are focused on a 12-month timeframe or less. These include ‘relative valuations’ to competitors and analysts’ price targets. These tend to reflect short‑term economic noise, interest‑rate shifts, and market sentiment.
Meanwhile, comparing a single firm’s key ratios to those of an entire index is meaningless. The index blends dozens of unrelated business models with very different structural valuations. It is rather like saying that this apple is cheaper than this fruit salad — therefore, it is undervalued.
By contrast, a discounted cash flow (DCF) analysis allows investors to model the full arc of a company’s future cash flows, including growth, margins, reinvestment, and risk.
How much of a bargain is it?
DCF modelling does this by projecting a business’s future cash flows and discounting them back to today to create a per-share price.
The higher the level of uncertainty about those cash flows, the higher the discounts applied. The assumption and others mean analysts’ DCF outcomes can differ. But using my own inputs — including a 9.1% discount rate — Melrose appears 52% undervalued at its present £4.65 level.
That places fair value near £9.69 — more than twice the current price. If markets continue drifting toward fair value, this could be a tremendous potential buying opportunity if those DCF assumptions hold.
How does the growth engine look?
The engine driving any stock’s price to its fair value is sustained profit growth. A risk here for Melrose is defence budget delays to long‑cycle aerospace programmes that could push back cash flow realisations. Another is any supply‑chain issues that could hold up production.
Nevertheless, analysts forecast its profits will grow by an average of 13.4% a year over the medium term at minimum.
This looks an underestimate to me, given its adjusted operating profit soared 20% year on year to £647m in its 2025 annual results released on 23 March this year.
Revenue in its key Engines division jumped 15% to £1.63bn, and free cash flow rocketed from a £74m outflow to a £125m inflow.
My investment view
Melrose combines strong structural demand with accelerating profitability, giving investors a rare blend of resilience and growth.
I would buy it if I could, but I already own two stocks in the defence sector (BAE Systems and Rolls-Royce), so owning another would unbalance my portfolio.
However, I do have my eye on other deeply undervalued shares, some with very high dividend yields too.
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Simon Watkins owns shares in BAE Systems and Rolls-Royce.
