Trading Strategies: is BAE Systems overvalued after 270% rally?

A weapon system on display at the IDEB Defence & Security exhibition this month in Slovakia. Photo: Robert Nemeti/Getty Images.

Stock market investors may naturally assume that there is a dearth of growth opportunities in the FTSE 100. After all, the recent surge in energy prices has already prompted a spike in inflation in the US and the eurozone, with the pace of price rises in the UK expected to follow suit. This could lead to monetary policy tightening over the coming months, weakening economic growth prospects and limiting scope for profit growth among UK-listed large-cap stocks that typically have international exposure.

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However, a surprising number of FTSE 100 members still offer strong earnings per share (EPS) growth forecasts over the next couple of years. Whether this is from robust industry growth prospects, the presence of a competitive advantage or, indeed, the contribution of a sizeable share buyback programme, it is still possible to unearth a wide range of large-cap stocks forecast to deliver double-digit annualised EPS growth in the medium term.

In fact, the main challenge facing investors is determining whether such stocks are worthy of the premium market valuations they currently command. With the FTSE 100 trading within 5% of its all-time high, having surged by 48% over the past five years, it now has a price/earnings (PE) ratio of 16.4. And for those stocks that offer the prospect of faster EPS growth than the wider index, investors can expect to pay a substantially higher earnings multiple at present.

Justifying high market valuations

Clearly, no investor wants to overpay for any stock. Purchasing shares that trade on a low PE ratio, after all, provides greater scope for an upward rerating that can have a further positive impact on capital gains. In some cases, however, faster-growing FTSE 100 shares appear to be overvalued at present. Such companies are, therefore, worth avoiding.

In other cases, though, relatively high market valuations can be justified based not only on EPS growth potential in the next couple of years, but also on the quality of a particular firm and, perhaps even more importantly, its long-term growth potential.

For example, it may be worth paying significantly more for a company that has a solid financial position. Modest debts and ample headroom when servicing its borrowings mean it is likely to be in a strong position to both overcome potential near-term economic turbulence, while also reinvesting for long-term growth or making acquisitions.

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Similarly, a firm that has a competitive advantage versus its sector peers may be worthy of a premium market valuation. This may take the form of strong customer loyalty that provides scope for pricing power, relatively high profit margins or a large market share, for instance, that could lead to favourable financial performance over sustained periods.

Indeed, companies that have robust underlying growth prospects are likely to be more valuable than their relatively cyclical index peers. For instance, firms that are set to benefit from fundamental changes to their industry prospects, including the impact of long-term growth trends such as an ageing global population, the world’s focus on achieving net zero or, more recently, a seemingly constant state of heightened geopolitical risks, may deliver consistently strong EPS growth over the long run. Such companies may be worthy of a premium price tag versus the wider FTSE 100.

Potential threats

Profit growth, of course, is never guaranteed. A seemingly infinite number of “known unknowns” and “unknown unknowns” can occur that derail even the most seemingly robust growth stock’s financial outlook. Recent examples include the impact of the Iran war on travel and leisure stocks, as well as the effects of the pandemic on a wide range of sectors.

Therefore, it is important for investors to seek to obtain a margin of safety wherever possible, take a long-term view and accept share price volatility is likely to be heightened for sustained periods of time. Doing so could help improve their chances of generating index-beating returns over the coming years.

Growth catalysts

Source: ShareScope, 21 May 2026. Past performance is not a guide to future performance.

Aerospace and defence company BAE Systems is a prime example of a potentially fast-growing FTSE 100 stock that trades on a premium market valuation. Having risen by 270% in the past five years, it now has a PE ratio of 23.2. At first glance, this may suggest it is grossly overvalued. However, when the firm’s growth potential and sound fundamentals are taken into account, it appears to offer a relatively favourable risk/reward opportunity on a long-term view.

Indeed, the company is currently forecast to post a 12% annualised rise in EPS over the next two financial years. This figure is set to benefit from a £1.5 billion share buyback programme announced in 2023 that began in July 2024 and is expected to complete within three years of its start date. According to the firm’s latest trading update, released earlier this month, £570 million of shares are yet to be repurchased.

A high-quality business

BAE’s EPS growth rate is also set to be boosted by a recent fundamental shift in attitudes among several major developed economies towards military spending. This was largely prompted by the emergence of elevated geopolitical risks following the commencement of war in Ukraine in 2022. 

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While NATO members previously aimed to spend 2% of GDP on defence each year, they committed during 2025 to raise that figure to 5% by 2035. Given that NATO includes several large economies such as the US, Germany and the UK, a three percentage point rise in the proportion of GDP spent on the military is likely to provide a significant catalyst for the financial performance of defence sector incumbents over the coming years.

Alongside its attractive near and long-term growth potential, BAE has sound fundamentals that suggest it could be worthy of a premium market valuation. For example, its net debt-to-equity ratio of 47% and net interest cover in its latest full year of 8.3 indicate that it has the financial means to overcome an uncertain period for the world economy. Its financial position further suggests that it has the capacity to engage in M&A activity following acquisitions made in recent years to bolster long-term profit growth potential.

Risk/reward ratio

Clearly, the link between defence spending and GDP means that an uncertain global economic outlook could negatively impact BAE’s financial prospects. Although its recent trading update stated it is on track to meet financial guidance for the full year, the company, as per its FTSE 100 index peers, is not immune to changes in the economic outlook. Alongside a highly fluid situation regarding the war in Iran, this could mean that its share price is relatively volatile in the short run.

However, the world economy has an excellent track record of recovering from even its very worst downturns. In fact, it has typically reverted to its long-term average growth rate over multi-year time periods. This means that the long-term outlook for BAE amid an upbeat future for the defence industry is encouraging.

As a result, it appears to offer good value for money despite its premium market valuation. The company’s strong underlying growth potential and solid financial position mean it could be well placed to deliver FTSE 100-beating returns in the coming years.

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