BAE Systems (LSE: BA.) shares have been surging, yet investors could be wondering if the rally is only just beginning. With geopolitical tensions escalating and NATO allies ramping up defence budgets, could this be a generational buying opportunity?
Why the defence giant is thriving
As I write early on 3 March, the stock trades at 2,240p following recent stellar results and last weekend’s tragic escalation of conflict in the Middle East.
The company reported underlying earnings per share growth of 12% for 2025, driven by record order intake across all divisions.
The order book now stands at £74bn, providing strong revenue visibility that few others in the FTSE 100 Index can match. Add to that the current state of the world and it’s no wonder investors are eyeing the company’s shares.
UK defence spending is set to reach 2.5% of GDP by 2027, while Germany has committed €100bn to military modernisation.
Ongoing conflicts in the Middle East could well accelerate procurement cycles, with BAE winning significant contracts for combat aircraft, naval vessels, and munitions.
The specialised nature of defence manufacturing creates hefty barriers to entry, limiting competition and supporting pricing power.
The company’s cash flow generation remains robust, meaning management can return capital to shareholders through dividends and buybacks while investing in the future. The dividend yield currently sits at 1.6% as I write, lower than many Footsie peers but supported by strong earnings growth.
We haven’t really seen an investing environment like this in the last decade. Interest policy and inflation concerns remain. The Ukraine-Russia war continues, overshadowed by the US-Iran conflict.
This could represent a significant structural shift in global defence spending. BAE Systems could be well-placed for a significant shift in valuation expectations relative to the last 10 years amid the chaos.
The risks that can’t be ignored
While the opportunity is tempting, investors must weigh several company-specific factors.
BAE faces intense competition from US defence giants like Lockheed Martin which benefit from higher US defence spending and often superior technology.
Winning international tenders against these rivals requires constant innovation and competitive pricing, which can pressure margins.
Maintaining profitability on fixed-price contracts is also an ongoing challenge. Defence programmes frequently experience delays and cost overruns, and BAE must execute flawlessly to protect margins on multi-year projects.
Any significant programme setbacks could damage both its financials and reputation.
And the stock is currently valued at a forward price-to-earnings (P/E) ratio of around 26 times. That means the positive outlook may already be priced in.
My verdict
In my view, the stock represents a rare combination of strong market position, good earnings visibility and favourable industry dynamics.
The company is sadly benefiting from geopolitical tension and increased defence spending, even though we wish it wasn’t. There’s limited competition in specialised areas too.
However, it doesn’t come cheap. The share price reflects high growth expectations. There are also still big risks including programme delivery and ties to government spending. Investors also need to be comfortable with the ethics of investing in the sector.
The current valuation isn’t a historical bargain for BAE Systems shares. However, its huge potential and structural changes happening in the defence sector could mean it’s not this ‘cheap’ again in the next decade. In my eyes, that makes it an opportunity to consider.
