The BAE Systems‘ (LSE:BA.) share price has surged over the past two years as geopolitical tensions have morphed into conflict. The stock is up 33% over 12 months and 89% over two years. It’s been a phenomenal rise.
However, the share price has demonstrated some weakness in recent weeks, falling back from above £11. The stock is currently trading for £10.61. So are we looking at a buying opportunity?
The buy case
BAE Systems operates in the defence industry, which naturally tends to perform well during times of geopolitical uncertainty and conflict. Increased demand for defence capabilities can positively impact the company’s revenue and profitability.
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While, in theory, conflict in Ukraine and Palestine could come to an end at any moment, BAE’s tailwind is associated with the broader increase in government military spending that has already occurred.
Countries across Europe and around the world have already committed to long-running defence programmes that are unlikely to be canned any time soon.
Value for money?
Valuation is the most important factor to consider when making an investment.
One of the most simple valuation metrics is the price-to-earnings (P/E) ratio. This is calculated by dividing the company’s earnings per share (EPS) with the current share price.
In the table below, I’m comparing the defence contractor’s 2022 earnings with estimates for 2023-2025. I’m also using this data to provide a P/E ratio for each year.
| 2022 | 2023 | 2024 | 2025 | |
| EPS (p) | 55.5 | 59.3 | 63.5 | 70.2 |
| P/E | 19.1 | 17.9 | 16.7 | 15.1 |
The data shows BAE is expected to experience strong EPS growth over the medium term. This is very important as we don’t want to invest in companies that aren’t moving forward.
However, the above P/E ratios show that BAE doesn’t come cheap, trading at a premium to the index. Nonetheless, investors are normally willing to pay a premium for growth.
Using a growth-adjusted metric — the PEG or price/earnings-to-growth valuation — BAE doesn’t look bad value, but it doesn’t look great either. PEG builds on the P/E ratio by considering expected earnings growth and not just current earnings.
BAE has a PEG ratio of 1.3. Now, a PEG under one normally suggests a buying opportunity as the stock is undervalued. However, factoring in the dividend yield of 2.5% to the PEG ratio of 1.3, I’d suggest the stock is trading around fair value.
Other considerations
Of course, the defence industry isn’t the same as retail sectors. To some extent, revenues and earnings can be easier to forecast, but it’s also hard to factor in certain tailwinds.
BAE prospers in times of war, and geopolitical tensions are very high with potential conflict zones around Taiwan and Iran, to name just a couple.
Taiwan, for example, is a massive defence market, and one that US contractors are struggling to supply. There’s also more potential tailwinds in the form of AUKUS (the security partnership for the Indo-Pacific region between Australia, the UK, and the US) and its possible expansion.
So while I don’t think BAE Systems looks like great value right now, I’ll keep it on my watchlist.
