Defense Stock, Offensive Valuation

What is it you look for when researching a new investment? Whether you're a value investor or a growth investor, you probably have a few basic "wants" that you keep an eye out for. You want to find a company that's increasing revenues and earnings (Symantec (Nasdaq: SYMC), for instance). One that's paying down debt or piling up cash -- or both (as U.S. Steel (NYSE: X) is doing). A company that keeps inventory under tight control (rememberGap's (NYSE: GPS) problems with this?). One that shows positive free cash flow (one of Hasbro's (NYSE: HAS) specialties). And maybe even one that stands a chance of benefiting from global trends (think Exxon Mobil (NYSE: XOM) and rising oil prices).

One company that's been putting all of these elements together is defense stalwart Raytheon (NYSE: RTN). The company reported strong third-quarter earnings last week, boosting revenues 13% year-on-year and swinging to a net profit of $0.34 per share after last year's $0.08 loss. Raytheon also paid down $1 billion of long-term debt while simultaneously depositing $460 million in its bank account. Despite the rise in sales, its inventories have actually fallen slightly. It's projecting 2004 free cash flow to come in well over the $1 billion mark and to continue rising -- perhaps at double-digit rates in 2005. And of course, there are few companies better situated to thrive during a global war on terrorism than defense contractors such as Raytheon. (Aside from sharing the company's own good fortune, investors may also benefit from consolidation in the defense sector, with larger contractors such as Europe's EADS and America's General Dynamics (NYSE: GD) said to be on the hunt and paying premiums to acquire smaller rivals.)

Unfortunately for investors who do not already own the company, Raytheon's valuation already fully reflects this confluence of "good grades." Its stock currently sports a hefty 38 trailing P/E ratio. Its enterprise value-to-free cash flow ratio is lower, at 20, so the company is not really as overpriced as its GAAP numbers make it seem. But however you measure it, Raytheon's share price is probably too high for a company that analysts expect to grow profits at 12% per annum.

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For more Foolish defense news, read:

• Lockheed Martin Gains Altitude
• Defense Budget Boom
• Will the Navy Scuttle Shipbuilders?
• Bulletproof and Ready for Terror

Fool contributor Rich Smith owns shares of Hasbro, but none of the other companies mentioned in this article.