BAE Systems (LSE:BA.) shares are up 70% over two years. This means that £10,000 invested then would be worth £17,000 today, plus around £600 in the form of dividends. Clearly that’s a return most investors would be happy with. However, the question remains as to whether the FTSE 100 company actually deserves this elevated valuation. Let’s explore.
Putin and Trump send defence stocks higher
European defence stocks have surged since Vladimir Putin’s war in Ukraine started three years ago, ushering in a new era of heightened military spending. And now President Trump’s talk of a freeloading Europe has engendered a whole new wave of defence spending.
German company Rheinmetall is leading the way with over 1,000% in share price appreciation. And BAE hasn’t performed badly either, more than doubling in value since the beginning of the war.
However, some of the valuations we’re seeing now exceed expected norms. BAE is currently trading at 22.5 times forward earnings, which actually puts it at a premium to its American peers — something most people wouldn’t have expected.
The current consensus forecast sees the price-to-earnings (P/E) ratio falling from 22.5 times in 2025 to 19.8 times in 2026 and then 18.2 times in 2027. While this isn’t a bad rate of growth, it’s subpar according to famed investor Peter Lynch’s price-to-earnings-to-growth (PEG) ratio.
The former Fidelity Fund manager said that a PEG ratio under one suggests a stock is undervalued. However, BAE’s PEG ratio is 1.9. Even when adjusted for the 2.1% dividend yield, the stock appears to be substantially overvalued. Perhaps by as much as 70%.
Huge barriers to entry?
Some stocks can trade with higher PEG ratios because the very-long-term outlook is positive or because there are very high barriers to entry in their sectors. And on that second point, defence has long been considered a sector with high barriers to entry. Traditionally, it has been hard to become a government contractor as a new entrant.
However, I’d argue that things are changing. We live in a world whereby military supremacy is not solely defined by who has the best hardware, but one where software and small attritable systems are becoming indispensable. This has allowed new players to enter the market, including the likes of Anduril, which specialises in autonomous systems. We’re also seeing commercial UAVs weaponised. The environment is evolving.
This shift necessitates a re-evaluation of what constitutes a valuable defence investment. It’s no longer solely about the size of a nation’s arsenal, but also about the agility and adaptability of its technological infrastructure. Established defence giants still possess advantages in terms of scale and established relationships. However, their ability to innovate and integrate these newer technologies is being challenged.
Investors should, therefore, consider whether a high PEG ratio is truly justified for these legacy players, or if future growth lies with the smaller, more nimble companies driving this technological revolution in warfare. Because of these concerns, I’m not adding BAE to my portfolio any time soon, but appreciate it could go higher on speculation about increased defence spending.
This post was originally published on Motley Fool
