Trading Strategies: are BAE Systems shares now overvalued?

Having experienced a correction in early April, the FTSE 100 has surged by 14% in less than three months. In doing so, it has moved within touching distance of an all-time high, with the index currently trading less than 2% below its record level.

• Invest with ii: Open a Stocks & Shares ISA | Top ISA Funds | ISA Offers & Cashback

While this may prompt heightened investor exuberance, as capital gains typically lead to a more bullish outlook, those investors with a more rational tilt may worry that stock market valuations are now reaching their peak in some cases. Indeed, overpaying for shares is a common mistake made by professional and private investors alike that can lead to highly disappointing results over the long run.

Lacklustre performance

Of course, it’s important to put the FTSE 100’s current price level into perspective. Prior to its recent surge, the index’s performance can be described as “lacklustre” at best. While the S&P 500 has more than doubled in the past five years, the UK’s blue-chip index has produced a gain of just 42%. Looking even further back, the FTSE 100 currently trades just 27% higher than it did at the turn of the century.

Therefore, it could be argued that, rather than now being overvalued, the UK’s large-cap index is merely less undervalued than it was prior to its recent gains. This may mean that substantial further growth lies ahead.

In fact, with the index set to benefit from an upbeat global growth outlook due to its international focus, many of its incumbents could be well placed to experience improved profit growth. Indeed, previous interest rate cuts, as well as likely further monetary policy easing, may have a significantly positive effect on the world economy’s growth rate.

Premium valuations

Furthermore, the FTSE 100 contains several high-quality companies that may be worthy of premium valuations. For example, in some cases they have solid balance sheets that could allow them to overcome periods of temporary economic difficulty which, history suggests, are almost inevitable. Sound finances may also enable them to capitalise on the economy’s long-term growth potential via reinvestment or acquisitions.

• Stockwatch: unpacking this growth share conundrum
• Why Warren Buffett could back Britain in final mega-deal

Similarly, companies that enjoy a competitive advantage, such as via significant customer loyalty or lower costs, may be worthy of a higher market valuation. They could perform relatively well if geopolitical risks, such as a global trade war and conflict in various regions, lead to a limited period of slower economic growth in the short run. They may also be able to implement aggressive price rises as the world economy undergoes an increasingly ebullient period over the long run.

Margin of safety

Such companies may never have ratings that are below, or even in line with, those of the wider index. And by continually avoiding such firms, there is a risk that investors end up buying lower-quality stocks that, while priced more cheaply, fail to offer significant scope for capital gains as their earnings growth rates prove to be a relative disappointment.

Investors, though, should always ensure that they obtain a margin of safety when purchasing stocks. Certainly, this is more difficult to achieve following the FTSE 100’s recent rally. But it is crucial to not become carried away with increasingly upbeat earnings growth forecasts that, even if met, may already have been priced in by investors. Indeed, present risks such as tariffs on imports, as well as ‘known unknowns’ that cannot be predicted ahead of time, could yet prompt a sharp stock market correction as per April this year.

By demanding at least some discount to a stock’s intrinsic value, investors may be able to limit their prospective paper losses in such a scenario while experiencing relatively attractive gains as a likely recovery takes hold in the long run. While the FTSE 100’s current price level and recent rise may suggest that unearthing such discounts could prove challenging, several large-cap shares continue to offer fair value for money given their solid fundamentals and long-term growth prospects.

Rising defence spending

Source: ShareScope on 27 June 2025. Past performance is not a guide to future performance.

Aerospace and defence firm BAE Systems (LSE:BA.) appears to have an upbeat long-term outlook. It is well placed to benefit from a material shift in attitudes towards military spending across developed economies, largely as a result of conflict in Ukraine and elsewhere. That means the proportion of GDP spent on defence is moving significantly higher.

Indeed, NATO members recently agreed to raise the target of GDP spent on defence from 2% to 5% over the next decade, with 3.5% allocated to core defence spending. Given that NATO includes several of the world’s largest economies, this is set to markedly increase demand for defence-related equipment. And with the world economy’s growth rate set to be bolstered by the impact of interest rate cuts, demand for BAE’s products is likely to experience a further boost over the coming years.

A high-quality company

As well as having an upbeat long-term growth outlook, the company has solid fundamentals. For example, its latest annual results showed that it has a net debt-to-equity ratio of 58%, while net interest costs were covered 7.6 times by operating profits during the year. This means the company is in a strong position to not only overcome potential economic challenges in future, but also to reinvest for long-term growth and make further acquisitions following recent M&A activity to improve its competitive position.

Encouragingly, BAE’s latest trading statement showed that it is performing in line with previous expectations. It is on track to meet financial guidance for the current year, with revenue expected to rise by 7-9% and earnings per share forecast to increase by 8-10%. With its latest annual results showing an £8 billion rise in its order backlog to £77.8 billion, the firm has relatively good visibility in its financial performance over the coming years.

Share price rise

Of course, investors have become increasingly optimistic about the company’s long-term financial prospects amid rising defence spending and an improving economic outlook. BAE’s share price has risen by 62% since the start of the year, which is 56 percentage points ahead of the FTSE 100’s gain over the same period.

• Ian Cowie: investment trusts to play this soaring sector
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

As a result, the stock now trades on a forecast price/earnings ratio of 25.3. Clearly, this is exceptionally high relative to many other UK-listed large-cap shares. In fact, some investors would argue that it is extremely high even when the company’s near-double digit earnings growth forecast for the current year is taken into account.

However, when the long-term prospects for the company amid a material rise in defence spending by major economies are factored in, BAE’s valuation starts to appear more attractive. And with its sound balance sheet and solid market position further highlighting its status as a high-quality company, it could reasonably be argued that the firm is worthy of its premium valuation versus the wider stock market.

Risk/reward ratio

Clearly, there are a whole host of cheaper FTSE 100 stocks available at present. But there is a significant difference between price and value, with the latter considering the quality of a company and its growth prospects. Therefore, while BAE offers only a limited margin of safety at present, it appears to be capable of delivering further index outperformance over the coming years.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.