BAE Systems (LSE: BA.) shares have been a very good investment recently. Over the last year, they’ve returned approximately 47% plus dividends.
Are the shares still worth buying today? Let’s take a look.
Supportive backdrop
In my view, the outlook for defence companies remains favourable in the short to medium term.
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Given the heightened level of geopolitical tension globally with the Russia-Ukraine war and China-Taiwan concerns, I can’t see governments cutting their defence budgets any time soon. This should provide a supportive backdrop for companies that operate in the industry, such as BAE Systems.
Plenty of analysts share my view. For example, analysts at Bernstein recently said that they expect 2023 to be a “strong” year for defence companies globally, citing the tense geopolitical environment and the implications for defence budgets. They have an ‘outperform’ rating on BAE Systems shares.
It’s worth noting that in December, the US Senate passed legislation authorising a record $858bn in annual defence spending – 11% higher than the year before. This defence spending growth is a positive development for BAE Systems, as it generates a large chunk of its revenues from the US government.
David Perry, a defence analyst at JP Morgan, believes that we’re at the start of a “five to 10-year global upturn” in defence spending.
Strong trading
Zooming in on BAE’s performance, the company’s most recent trading update, posted in mid-November, was quite encouraging.
The company said that order flow remains strong and that it’s well positioned for another year of top-line growth and margin expansion in 2023.
“We see sales growth coming from all sectors and opportunities to further enhance the medium-term outlook as our customers address the elevated threat environment,” said CEO Charles Woodburn.
So overall, the outlook for BAE Systems appears to be quite bright at present.
Valuation
What about the stock’s valuation though? Is there room for further share price upside after the stock’s near-50% gain over the last 12 months?
Well, at present, analysts expect BAE Systems to generate earnings per share of 57.8p for 2023. That puts the stock on a forward-looking price-to-earnings (P/E) ratio of about 14.5.
To my mind, that’s a fair valuation. In other words, I wouldn’t expect to see a lot of multiple expansion from here.
So I’d expect investment returns to be a little more normalised going forward and in line with earnings growth and dividends.
Speaking of dividends, analysts currently expect BAE to pay out 28.4p per share for 2023. That equates to a yield of around 3.3% at the current share price, which is healthy. The estimated dividend coverage ratio is around two, indicating that there’s little chance of a dividend cut.
Risks
Of course, there are risks to consider.
One is a change in sentiment towards defence stocks. If the Russia-Ukraine crisis was to come to a sudden end, for example, we may see investors move out of the sector, pushing share prices down.
Another risk is debt. At 30 June, this stood at £5.1bn. This is something to keep an eye on in a rising interest rate environment.
My view on BAE Systems shares
Overall however, I like the risk/reward here. It’s not a stock I’d bet the house on. But I’d be comfortable with a small position as part of a diversified investment portfolio.
