LONDON -- The FTSE 100 has risen by 25% over the last year, and many top shares are beginning to look quite expensive.
I'm on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I'm using a special version of the price to earnings ratio called the PE10, which is one of my favourite tools for value investing.
The PE10 compares the current share price with average earnings per share for the last ten years. This lets you see whether a company looks cheap compared to its long-term average earnings.
Today, I'm going to take a look at the PE10 for the defence giant BAE Systems (LSE: BA) (OTC:BAES.Y).
Is BAE Systems a buy?
In April last year, I bought some BAE shares for less than 300 pence per share, expecting to enjoy the 6.5% yield they offered at that time, without hoping for huge capital gains.
As it happens, the shares have recovered from the wobble they experienced after the BAE's failed merger with EDS, and have delivered a 45% gain over the last 12 months.
BAE looked good value at under 300 pence, but how does it look at today's 405 pence share price? Let's take a look at the firm's current price-to-earnings ratio, and its PE10:
BAE's current 2012 P/E of 12.3 looks quite attractive, especially given the firm's 5% prospective dividend yield. However, a PE10 of 18.1 makes BAE's shares look quite expensive, compared to its long-term average earnings.
At this price, BAE is a hold, in my view.
A brighter future?
BAE is performing well at the moment, but it has reported a full-year loss in three of the last 10 years. The firm remains vulnerable to any major changes in U.S. and U.K. defense spending, as the majority of its income comes from these two countries.
However, in 2012, BAE did manage to increase its total of non-U.S./U.K. orders to £11.2 billion, up from £4.8 billion in 2011, which is encouraging, and should improve the diversity of its future earnings.
On the downside, I was disappointed to see that BAE continued with its share buyback program in May, despite the firm's share price rising to over 400 pence, a level not seen since early 2009.
As a shareholder, I'm not sure this is good value for money, and would rather see purchases made when the share price is weaker, or not at all.
Can you beat the market?
If you already own shares in BAE Systems, then I'd strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top U.K. fund manager Neil Woodford's eight largest holdings.
Mr. Woodford's track record is impressive: if you'd invested £10,000 into his High Income fund in 1988, it would have been worth £193,000 at the end of 2012 -- a 1,830% increase!
This special report is completely free, but availability is limited, so click here to download your copy immediately.