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BAE Systems (LSE: BA.) shares have enjoyed an incredible run-up of late. The share price is up 329% in the last five years. It’s up 20% so far this year alone!
With a valuation that is beginning to look frothy and plenty of reasons to think the optimism could be overdone, I’m wondering what to do about my own position in the company. Should I get out while the going is good?
To my mind, the current heady valuation is certainly a risk. BAE Systems trades at around 30 times earnings. Few other FTSE 100 stocks command such a high premium on the shares. That would even be on the higher side in the US.
Why is this a problem? Because buying companies for the price of 30 years of earnings is a risky value proposition. The expectation is that there is going to plenty of growth in the firm’s profits to make it worth it.
Higher P/E stocks are more at risk should any economic turbulence head our way. In the event of a crash or correction, BAE Systems might be more affected than cheaper-looking stocks.
One analyst to think along these lines is Deutsche Bank, which recently downgraded the stock from a Buy to a Hold. The new share price target is 2,140p. What’s the reason for the downgrade? One is that BAE Systems may not exceed 2025 expectations after shrinking margins in its Maritime division.
The good
While a little caution is advisable when looking at any stock, I think the good outweighs the bad here.
The real story with BAE Systems and defence stocks in general is the ramping up of defence spending globally. NATO members have been speaking for years about raising military spending to higher amounts of GDP. We’re starting to see the fruit of that now.
Only this January, the firm “received a $184 million contract from the U.S. Marine Corps for the production of 30 additional Amphibious Combat Vehicles”. This order came on the back of a £8bn deal to supply Turkey with Eurofighter Typhoon fighter jets. BAE Systems now boasts a record order backlog of close to £80bn.
Donald Trump is making bold claims of raising America’s already sky-high spending by another half a trillion dollars or so. That’s a particularly important one for BAE Sysems, which derives around 50% of its revenues across the Atlantic. It’s worth noting that such an uncertain environment in the US is also somethingg of a risk for a business that draws so much of its cash flow from there.
The last word? BAE Systems shares looks like a more expensive buy than it has done for years, perhaps ever. But the rapid growth in orders might make it worth the premium. I’d call it one to consider.
