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CAPE Ratio Overview and Formula

The metric was invented by American economist Robert Shiller and has become a popular way to understand long-term stock market valuations. The CAPE ratio, short for cyclically-adjusted price-to-earnings ratio, is a valuation metric for stock prices and indexes. Invented by economist Robert J. Shiller, it’s also known as the Shiller P/E ratio. While high CAPE ratios are generally considered a predictor of poor future returns, there’s debate over how accurate this metric is.

Finally, using the CAPE ratio as a broad-market benchmarking tool can result in inaccuracies due to mega-cap companies. In cap-weighted indices, significant movement at the top can skew any P/E metric. Shiller and Campbell expounded on Benjamin Graham’s aggregate average concept with a practical method of calculating earnings-per-share over the course of an entire economic cycle.

  1. A company’s profitability is determined to a significant extent by various economic cycle influences.
  2. In addition to a decade in banking and brokerage in Moscow, she has worked for Franklin Templeton Asset Management, The Bank of New York, JPMorgan Asset Management and Merrill Lynch Asset Management.
  3. For example, many companies have moved toward share repurchases rather than dividends as a way to distribute cash to shareholders.
  4. As the CAPE Ratio tends to be a popular measure that is widely measured, a number of capable Industry experts have regarded this utility to serve as the predictor for the stock market returns in the future times.

The formula to calculate the Shiller P/E Ratio is the current price of a stock or index, divided by the 10-year average earnings, adjusted for inflation. The CAPE ratio for the S&P 500 index is considered one potential indicator of a future stock market crash. There has been a correlation between market crashes and the CAPE ratio. However, critics believe the CAPE measure has little predictive value.

Profit peaks and troughs are extremely common as consumer spending habits change significantly in periods of economic boom or bust. Taking these swings into account can help show whether a company will perform in the long run and is worth investing in. It is often applied to leading stock market indices, such as the S&P 500 or individual stocks, as an indicator of potential overvaluation or undervaluation compared to the assumed intrinsic value. When we have calculated the CAPE ratios, we have also always included negative earnings. This is the reason why the ratio is so high for the Italian stock market. The companies part of the Italy’s benchmark index, FTSE MIB, posted negative total earnings for the fiscal year of 2011 and for the fiscal of 2013.

CAPE Ratio and Market Crashes

Moscow’s stock market has always look cheap across all different valuation ratios and multiples but it has become painfully obvious to all Western investors that the Russian stocks have been cheap for a reason. The utmost important point here is that the CAPE ratio trading signals can be also applied to any type of indices to get an idea about whether the market is over-valued or under-valued. The CAPE Ratio generally gets applied to a scenario of broad equity indices for assessing whether the given Market is overvalued or undervalued.

Example of the CAPE Ratio

For the latest data, check the Professional Subscription Plan to our Global Equity Valuations data that provides CAPE ratios of more than 35 nations/regions/indices on a monthly level for the past 25+ years. Here’s an overview of General Electric’s business and whether the stock would benefit investment portfolios. Critics of the CAPE ratio contend that it is not very useful since it is inherently backward-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.

Or you can use resources like Shiller’s Yale website, which already has done most of the heavy lifting for you. To do that, you’ll need to find an index’s EPS for each of 10 years, adjust each for inflation to bring it into current dollars and find their average. Discover how to increase your chances of trading success, with data gleaned from over 100,00 IG accounts. A low CAPE ratio may suggest that stocks are undervalued and could be a good time to buy.

How to calculate the CAPE ratio

In other words, predicting future earnings cannot be accurate unless average earnings for five to ten years are considered and the results are adjusted for inflation. However, the earnings volatility rate is low during a more extended period as it smoothes out the fluctuations and business cycle consequences on the company’s earnings. CAPE is a measure that uses the price-to-earnings ratio to evaluate a company’s long-term financial performance while minimizing the economic cycle’s impact. It is also known as Shiller P/E, which is often used to assess the S&P 500 stock market in the US. 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 idea is that company earnings tend to be volatile and cyclical fluctuations and can significantly impact the traditional P/E ratio. However, it is important to remember that the CAPE ratio is not a perfect predictor of future earnings potential. The P/E ratio is the price of a stock, divided by its earnings in a single year.

Furthermore there is a good chance that most readers will already have a strong opinion on the effectiveness of the metric. For those who have not heard of it, and for those whom might need a refresher, here is a brief description of the CAPE Ratio. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The difference between the Shiller P/E ratio and the traditional P/E ratio is the time period covered in the numerator, as we mentioned earlier. In practice, the use-case of the CAPE ratio is to track broad market indices, namely the S&P 500 index.

What is the Meaning of CAPE Ratio?

The principles of buying low valuation and selling over valuation work everywhere. The correct action would have been selling into the US overvaluation and deploying capital into undervalued markets. Professor Jeremy Siegel from the Wharton School of Business suggests that using operating earnings instead of GAAP earnings may enhance the predictive power of the Shiller P/E. Russia currently has the world’s lowest cyclically adjusted price-to-earnings ratio or CAPE.

The problem is that standard P/E ratios depend on short-term changes in a company’s earnings performance that have little to do with its fundamentals and lots to do with big market-moving economic events. These can include things like a market correction, a recession or big changes in a company’s industry. For example, if a company’s stock price is $100 and its earnings per share over the past 10 years have averaged $10, then its CAPE ratio would be 100/10, or 10. It is a variant of the more popular price to earning ratio and is calculated by dividing the current price of a stock by its average inflation-adjusted earnings over the last 10 years. This ratio helps evaluate whether the stock price has been overvalued or undervalued for an extended period. Keep in mind that the stock price is undervalued if the cape ratio is higher than the P/E ratio.

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