Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Late last year, AeroVironment (AVAV 0.57%) hit an air pocket. Shares of the small drone maker -- a Pentagon favorite -- tumbled 11% in a day last November after a noted short-seller published a report warning that sales were "in a stall," free cash flow was drying up, and the company was "headed for a hard landing." One month later, AeroVironment came roaring back. Boosted by a powerful fiscal Q2 earnings report, shares jumped 31% and put its critics to shame.

And that could be only the beginning.

Drone firing rockets at a tank

Stifel predicts AeroVironment stock will win the game of drones. Image source: Getty Images.

Upgrading AeroVironment

Encouraged by what it views as strong prospects for continued growth over the next three years, analysts at Stifel Nicolaus announced this morning that they're upgrading AeroVironment stock to buy and assigning the shares a $65 price target -- nearly 50% higher than their previous $45 target, and about 40% above where the stock trades today.

What is it that makes Stifel so confident in AeroVironment's prospects?

Statistics and speculation

Let's begin with what AeroVironment said last year. In its fiscal Q2 2018 earnings report, AeroVironment firmly rebutted Spruce Point's allegations that sales were stalling, reporting 47% year-over-year sales growth, with improved gross margin of 42%.

Granted, three months later AeroVironment's Q3 report didn't look so grand. the drone company reported a small quarterly loss, and missed analyst estimates. Still, sales were up 20% year over year, and much of the company's loss was attributable to the one-time event of expenses taken to account for the new Tax Cut and Jobs Act of 2017.

What really worried investors last quarter, of course, was management's conservative guidance for the full fiscal year: sales ranging from $280 million to $300 million, and earnings of $0.45 to $0.65 a share. Arguably, it wasn't so much the tax reform-related GAAP loss last quarter but AeroVironment's guidance for full-year results that really sank the stock in March.

What Stifel sees ahead

And yet, if you ask Stifel Nicolaus, the future for AeroVironment could be a whole lot brighter than what management's conservative guidance suggested. In a write-up covered on TheFly.com this morning, Stifel laid out its case for buying AeroVironment today:

Heightened defense spending by the Trump administration, argues Stifel, will provide a tailwind driving AeroVironment stock forward. Over the next 12 to 36 months in particular, Stifel sees a real potential for AeroVironment's Switchblade kamikaze drone to transform its business.

In that regard, just two days ago AeroVironment announced a new initiative in cooperation with the U.S. Navy's Coastal Riverine forces to pair unarmed Puma surveillance drones with Switchblade attack drones to create a "sensor-to-shooter" system to counter the threat that small, fast attack boats pose to Navy warships. AeroVironment said that it plans to begin deploying this system for the Navy this coming fall, creating a new revenue stream for the company.

Stifel says that Switchblade is only one element in "as strong a pipeline of opportunities" as the company has had in the last 10 years. To that I'd add that new reports out of the Pentagon concerning evidence that Russia has found a way to jam communications between U.S. ground controllers and their drones could spur a new round of upgrades of drone communications systems -- providing additional revenue opportunities for AeroVironment.

What it means for investors

Mind you, even if all of the above is true and correct, it doesn't necessarily mean that Stifel Nicolaus is correct to recommend buying AeroVironment stock, the valuation of which still seems exceedingly high.

With a market capitalization of nearly $1.1 billion, AV stock sells for nearly 34 times trailing earnings -- a bit pricey given that most analysts who follow the stock predict AeroVironment earnings will grow at only 20% annually over the next five years. Free cash flow at the company also looks weak relative to reported net income, with actual cash profits for the past 12 months of $21.3 million backing up only about 66% of reported net income. Valued on free cash flow, AV stock sells for a price-to-free-cash-flow ratio of closer to 51.

Even if I agree that the growth story for AeroVironment and for drones in general is bright (and I do), I still worry that AeroVironment stock is too richly valued to justify a buy rating at today's prices.