Defense Stocks Just Got Even More Expensive

Key Points

• For the first two decades of the 21st century, defense stocks sold for an average of 1.4x sales.

• Today, these same defense stocks cost twice as much.

• The defense sector is booming, yes. But the risk is also rising.

• These 10 stocks could mint the next wave of millionaires ›

For more than a year now, I've been warning investors that defense stocks cost too much. At first, that warning seemed prescient, when shares of almost all of America's leading publicly traded defense companies declined within months of my sounding the alarm. Fast forward nearly a year, and things have gotten both better... and worse.

The better: Defense stock prices bounced back (which should make current shareholders happy).

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The worse: As of today, almost all defense stocks look more overpriced than ever before. For anyone looking to buy new shares of defense stocks, this is bad news.

Image source: Getty Images.

What history says about defense stocks

How do I come to these conclusions? By looking at the data.

Over the 10-year period running from 2004 to 2013, over the 10 years running from 2014 to 2023, and over the 20-year period running from 2004 to 2023, I've calculated the average enterprise value-to-sales ratios (EV/S) for each of 10 major U.S. defense companies, using data from S&P Global Market Intelligence.

(As a reminder, EV/S ratios are similar to price-to-sales ratios, except that EV/S adjusts market capitalizations to factor in net cash on the balance sheet -- or, more commonly, net debt).

As you'll see below, these data show that defense companies early in the 21st century cost about 1x their annual sales, but that prices have been climbing steadily for the past decade. Averaging out the numbers, for the past 20 years defense stocks have cost about 40% more than their annual sales -- and this is the number I'm tentatively assuming to be the new "fair value" for defense stocks.

Data source: S&P Global Market Intelligence. * Huntington Ingalls data begins in 2011, the year when Northrop Grumman spun off Huntington Ingalls as a separate company. ** Leidos data begins in 2006, the year of its IPO. Data on its average enterprise value-to-sales ratio for 2014 is missing because the company changed its fiscal year in 2015, skewing the data somewhat.

Now we compare these 20-year-average numbers to what the stocks cost today. (To make it easier for readers to quality-check my numbers, I provide both EV/S, and more commonly available P/S ratios).

Data source: Yahoo! Finance.

What this means for defense stock investors

So what has changed since the last time we checked in on the defense stocks, three months ago?

Basically, every single one of these stocks, with the sole exception of Lockheed Martin, has gotten more expensive. Lockheed, if you recall, suffered a steep sell-off after reporting "a significant profit miss" last month caused by a near-$1 billion charge on "a classified aerospace project," and it still hasn't fully recovered from that misstep. But all the others have.

Again, this probably sounds like good news for investors who own defense stocks. But these stretched valuations bring with them a significant risk of future steep declines, for both existing and new buyers. The average EV/S ratio of this group, 2.77, means that defense stocks as a whole currently cost nearly twice what has historically been their fair value.

Will this decline happen tomorrow? Probably not. In fact, with military tensions continuing to rise in the South China Sea and elsewhere, active conflict persisting in the Middle East, and Europe still embroiled in its biggest land conflict since World War II, investors may keep betting on military stocks for quite some time.

But with valuations as extreme as what we see today, I simply don't see much reason to expect defense stocks to move higher. On the contrary, if I were to bet on it, my hunch is that over the next decade, defense stocks will underperform the S&P 500 by a significant margin.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends L3Harris Technologies. The Motley Fool recommends Lockheed Martin, RTX, and Textron. The Motley Fool has a disclosure policy.