CAPE Ratio
What Is the CAPE Ratio?
The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to streamline changes in corporate profits that happen over different periods of a business cycle. The CAPE ratio, involving the abbreviation for cyclically adjusted price-to-earnings ratio, was popularized by Yale University professor Robert Shiller. It is otherwise called the Shiller P/E ratio. The P/E ratio is a valuation metric that measures a stock's price relative to the company's earnings per share. EPS is a company's profit divided by the outstanding equity shares.
The ratio is generally applied to broad equity indices to assess whether the market is undervalued or overvalued. While the CAPE ratio is a popular and widely-followed measure, several leading industry practitioners have called into question its utility as a predictor of future stock market returns.
The Formula for the CAPE Ratio Is:
What Does the CAPE Ratio Tell You?
A company's profitability is determined to a critical extent by different economic cycle influences. During expansions, profits rise substantially as consumers spend more money, yet during recessions, consumers buy less, profits plunge, and can transform into losses. While profit swings are a lot larger for companies in cyclical sectors — like commodities and financials — than they are for firms in [defensive sectors](/defensivestock, for example, utilities and pharmaceuticals, few companies can keep up with steadfast profitability in the face of a deep recession.
Because volatility in per-share earnings additionally results in price-earnings (P/E) ratios that bounce around altogether, Benjamin Graham and David Dodd recommended in their seminal 1934 book, Security Analysis, that for examining valuation ratios, one ought to use an average of earnings over preferably seven or ten years.
Example of the CAPE Ratio being used
The cyclically adjusted price-to-earnings (CAPE) ratio initially came into the spotlight in December 1996, after Robert Shiller and John Campbell presented research to the Federal Reserve that suggested stock prices were running up a lot faster than earnings. In the winter of 1998, Shiller and Campbell published their groundbreaking article "Valuation Ratios and the Long-Run Stock Market Outlook," in which they smoothed earnings for the S&P 500 by taking an average of real earnings over the past 10 years, returning to 1872.
This ratio was at a record 28 in January 1997, with the main other instance (at that time) of a comparably high ratio happening in 1929. Shiller and Campbell asserted the ratio was predicting that the real value of the market would be 40% lower in ten years than it was at that time. That forecast proved to be remarkably prescient, as the market crash of 2008 contributed to the S&P 500 plunging 60% from October 2007 to March 2009.
The CAPE ratio for the S&P 500 climbed steadily in the second decade of this millennium as the economic recovery in the U.S. gathered momentum, and stock prices reached record levels. As of June 2018, the CAPE ratio stood at 33.78, compared with its long-term average of 16.80. The way that the ratio had previously just exceeded 30 out of 1929 and 2000 triggered a furious debate about whether the elevated value of the ratio portends a major market correction.
Limitations of the CAPE Ratio
Pundits of the CAPE ratio contend that it isn't very useful since it is inherently in reverse looking, rather than forward-looking. Another issue is that the ratio relies on GAAP (generally accepted accounting principles) earnings, which have undergone marked changes in recent years.
In June 2016, Jeremy Siegel of the Wharton School published a paper in which he said that forecasts of future equity returns utilizing the CAPE ratio may be overly pessimistic because of changes in the manner GAAP earnings are calculated. Siegel said that utilizing consistent earnings data like operating earnings or NIPA (national income and product account) after-tax corporate profits, rather than GAAP earnings, improves the forecasting ability of the CAPE model and forecasts higher U.S. equity returns.
Highlights
- The ratio considers the impact of economic influences by comparing a stock price to average earnings, adjusted for inflation, over a 10-year period.
- The CAPE ratio is like the price-to-earnings ratio and is used to determine whether a stock is over-or under-valued.
- The CAPE ratio is used to analyze a publicly held company's long-term financial performance while considering the impact of different economic cycles on the company's earnings.
