In an era of evolving geopolitical landscapes and shifting military priorities, the valuation of defence companies requires a distinct approach. Unlike other industries, defence firms operate under unique financial, technological, and geopolitical constraints.
We spoke with a hedge fund analyst to learn about the key financial metrics, the impact of government budgets, the role of classified technology, and common misconceptions in valuing defence companies.
Key Financial Metrics and Valuation Models for Defence Companies
Contrary to many industries that emphasize earnings per share (EPS) or revenue growth, defence companies focus on Return on Invested Capital (ROIC). Historically, particularly in Europe, defence firms have struggled to generate an ROIC greater than their cost of capital, largely due to the “Peace Dividend”—the post-Cold War reduction in military spending. However, recent geopolitical tensions have reversed this trend. For instance, Rheinmetall, a leading weapons and ammunition manufacturer, saw its ROIC jump from 10% in previous years to 18% last year, with estimates now ranging between 25-30%. This level of return, when compared to capital costs, is highly significant. Meanwhile, Leonardo, an Italian aerospace and defence company, has faced difficulties in scaling production. Their 2016 acquisition of a U.S. company resulted in substantial losses, illustrating the challenge of integrating large acquisitions in this sector.
The Influence of Geopolitics, Budgets, and Military Contracts
Defence company valuations are almost entirely tied to government spending. With NATO allies increasing defence budgets, particularly in Europe, the impact on valuations is substantial. During the Munich Defence Forum (February 14-16, 2025), leaders discussed raising defence spending from 2% to 3% of GDP. While this may seem like a small shift, in absolute terms, it represents a 50% increase of investment in military capabilities. Additionally, even if ongoing conflicts, such as the Russia-Ukraine war, were to conclude, defence companies would still be in demand due to stock replenishment needs. Much of the existing equipment used in conflicts originates from leading European nations, necessitating immediate replacement post-war. Furthermore, European military readiness requirements dictate a minimum of 30 days of sustained conflict capability, while Russia currently maintains a 100-day stockpile. To close this gap, European nations must triple their stockpiles, fueling further demand for defence companies. However, fiscal deficits in nations like Italy, France, and the UK could pose challenges in funding these expansions.
The Role of Technology, Intellectual Property, and R&D
Classified technology and intellectual property are major determinants of a defence company’s intrinsic value. While publicly available information provides a baseline for assessment, true insights come from industry events and defence briefings. One of the most pressing technological debates revolves around the role of drones versus manned aircraft. Will drones become competent replacements, or will manned aircraft retain dominance? Research investments in this area will shape the next generation of aerial warfare. Additionally, the aerospace domain is a growing concern. Europe, particularly firms like Thales, Boeing, and Leonardo, is losing ground in space technology compared to SpaceX. While Europe has historically focused on high-orbit satellites, SpaceX has demonstrated the viability of low-orbit solutions at a fraction of the cost—10 to 15 times cheaper. Even Boeing, a traditionally dominant player, has reported losses due to competition from SpaceX’s cost-effective approach.
Valuing defence companies requires a solid understanding of financial metrics, geopolitical developments, and technological advancements. With increased defence spending, stock replenishment needs, and longterm military contracts shaping the industry’s future, investors must move beyond outdated cyclical models and recognize defence as a structural sector with significant growth potential.
