P/E 10 Ratio

What Is the P/E 10 Ratio?

The P/E 10 ratio is a valuation measure generally applied to broad equity indices that use real per-share earnings over 10 years. The P/E 10 ratio likewise uses smoothed real earnings to eliminate the vacillations in net income caused by varieties in profit edges over a typical business cycle. The P/E 10 ratio is otherwise called the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio.

Understanding the P/E 10 Ratio

The ratio was popularized by Yale University professor Robert Shiller, creator of the bestseller "Irrational Exuberance," who won the Nobel Prize in Economic Sciences in 2013. Shiller attracted attention after he warned that the frenetic U.S. stock market rally of the late-1990s would end up being a bubble.

The P/E 10 ratio is based on crafted by renowned investors Benjamin Graham and David Dodd in their legendary 1934 investment tome "Security Analysis." The investors attributed irrational P/E ratios to temporary and sometimes extreme variances in the business cycle. To streamline a company's earnings a period, Graham and Dodd recommended utilizing a long term average of earnings per share (EPS) — like five, seven, or 10 years — when computing P/E ratios.

Step by step instructions to Calculate the P/E 10 Ratio

The P/E 10 ratio is calculated as follows: take the annual EPS of an equity index, for example, the S&P 500, for the past 10 years. Change these earnings for inflation utilizing the consumer price index (CPI) — that is, change past earnings to today's dollars. Take the average of these real EPS figures over the 10 years. Divide the current level of the S&P 500 by the 10-year average EPS number to get the P/E 10 ratio or CAPE ratio.

The P/E 10 ratio varies a great deal over time. As per data originally presented in "Irrational Exuberance" (which was released in March 2000, corresponding with the peak of the dotcom boom), and updated to cover the period 1881 to August 2020, the ratio has varied from a low of 4.78 in December 1920 to a high of 44.20 in December 1999. As of August 2020, the historic P/E 10 average was 17.1.

Utilizing market data from both estimated (1881 to 1956) and genuine (1957 forward) earnings reports from the S&P index, Shiller and John Campbell found that the lower the CAPE, the higher the investors' likely return from equities over the following 20 years.

Setbacks of the P/E 10 Ratio

An analysis of the P/E 10 ratio is that it isn't generally accurate in signaling market tops or bottoms. For example, an article in the September 2011 issue of the American Association of Individual Investors Journal noted that the CAPE ratio for the S&P 500 was 23.35 in July 2011.

Comparing this ratio to the long-term CAPE average of 16.41 would suggest that the index was more than 40% overvalued by then. The article suggested that the CAPE ratio provided an overly bearish view of the market since conventional valuation measures like the P/E showed the S&P 500 trading at a multiple of 16.17 (based on reported earnings) or 14.84 (based on operating earnings). Albeit the S&P 500 plunged 16% in one month from mid-July to mid-August 2011, the index subsequently rose more than 35% from July 2011 to new highs by November 2013.

Highlights

• The P/E 10 ratio is a valuation measure for equities that uses real per-share earnings over 10 years.
• The P/E 10 ratio additionally uses smoothed real earnings to eliminate net income changes.
• The P/E 10 ratio is otherwise called the consistently adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio.