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BAE Systems‘ (LSE:BA.) shares are up 90% over five years. There was some pull back during the pandemic but then the stock surged as Russia invaded Ukraine and as the conflict erupted in the Middle East. As a result, £10,000 invested in February 2020 would now be worth £19,000, plus dividends, which would have equated to around £1,200 during the period.
Clearly, that’s a pretty strong investment.
What’s behind BAE’s resurgence?
The stock’s resurgence reflects structural shifts in global defence priorities amid heightened and tragic geopolitical tensions. The company benefits from long-cycle contracts for advanced platforms like fighter jets, submarines and cyber systems, which provide multi-year revenue visibility — orders surged to £74.1bn in 2024, with a 12%-14% sales growth projection.
As such, unlike short-term ammunition demand, BAE’s strength lies in complex, multi-decade programmes such as the F-35 Lightning II, where it provides electronic warfare tech, and nuclear submarine projects. Moreover, geopolitical instability, including the Ukraine war and Middle East conflicts, has accelerated NATO defence spending.
Strategic acquisitions like Ball Aerospace expanded capabilities in space technology, aligning with the Pentagon’s focus on next-gen warfare. Exposure to the US market (45% of sales) provides insulation from regional budget fluctuations, while rising global military budgets underpin long-term growth.
Risks of investing today
BAE Systems is certainly benefitting from supportive trends in security systems demand, but it also faces operational risks from cost overruns on long-term contracts, exacerbated by volatile energy prices and supply chain disruptions. Profitability depends on accurate cost forecasting, with margin pressures possible if inflation persists.
Political shifts also pose threats. Potential US defence cuts — notably against non-US or traditional contractors — under new administrations could dampen growth. Moreover, while dividends (yielding 2.6%) appear sustainable, debt from acquisitions may constrain buybacks. Lastly, BAE’s growth narrative relies on sustained conflict-driven spending, which could unravel if geopolitical tensions ease unexpectedly.
The valuation conundrum
The company’s valuation metrics indicate a position of relative strength — it’s certainly not oversold. Its price-to-earnings (P/E) ratio is projected to fall from 19.3 times in 2023 to 15.6 times in 2025, suggesting improving earnings expectations.
The forward P/E of 17.9 is 9.7% below the global industrials sector median, indicating potential undervaluation compared to peers. In addition, BAE’s forward price-to-earnings-to-growth (PEG) ratio of 1.62 is 12.3% below the sector median, implying better value relative to growth prospects.
Notably, BAE now trades in line with US peers, which isn’t typical and may suggest limited room for further multiple expansion. The company’s forward P/E ratio is 25% above its five-year averages, potentially indicating that the stock’s currently trading at a premium to its historical valuation. This could signal that BAE’s stock may have limited potential for appreciation in the near term.
My take
BAE’s a stock I owned and sold too soon. However, I don’t have any desire to get back in. There’s an element of volatility based on geopolitical events that I don’t love, and the valuation doesn’t suggest undervalued conditions. Investors may want to consider other companies for defence exposure.
This story originally appeared on Motley Fool
