There's Reason For Concern Over BAE Systems plc's (LON:BA.) Price

BAE Systems plc's (LON:BA.) price-to-earnings (or "P/E") ratio of 22.1x might make it look like a sell right now compared to the market in the United Kingdom, where around half of the companies have P/E ratios below 16x and even P/E's below 9x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

Recent times have been pleasing for BAE Systems as its earnings have risen in spite of the market's earnings going into reverse. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors’ willingness to pay up for the stock. If not, then existing shareholders might be a little nervous about the viability of the share price.

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Is There Enough Growth For BAE Systems?

There's an inherent assumption that a company should outperform the market for P/E ratios like BAE Systems' to be considered reasonable.

Retrospectively, the last year delivered an exceptional 20% gain to the company's bottom line. The latest three year period has also seen an excellent 51% overall rise in EPS, aided by its short-term performance. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 9.0% each year as estimated by the analysts watching the company. With the market predicted to deliver 14% growth per year, the company is positioned for a weaker earnings result.

With this information, we find it concerning that BAE Systems is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.

What We Can Learn From BAE Systems' P/E?

It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

Our examination of BAE Systems' analyst forecasts revealed that its inferior earnings outlook isn't impacting its high P/E anywhere near as much as we would have predicted. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

A lot of potential risks can sit within a company's balance sheet. Take a look at our free balance sheet analysis for BAE Systems with six simple checks on some of these key factors.

Of course, you might also be able to find a better stock than BAE Systems. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.