Adjusted annualized p e ratio

The Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, often referred to as the Adjusted Annualized P/E Ratio or Shiller P/E, is a valuation measure used in equity valuation that smooths out cyclical fluctuations in earnings. It calculates the real price of a stock or market index divided by the average of ten years of inflation-adjusted earnings per share (EPS). This approach provides a more stable and less volatile metric than the traditional price-to-earnings ratio, offering a broader perspective on market valuations by accounting for varying business cycles.

History and Origin

The concept behind the Adjusted Annualized P/E Ratio was popularized by Nobel laureate Robert J. Shiller, an American economist, in his book Irrational Exuberance and in academic papers with John Y. Campbell. While value investors Benjamin Graham and David Dodd had earlier advocated for smoothing earnings over several years in their seminal work Security Analysis to get a better sense of a company's true earning power, Shiller significantly developed and applied this methodology to broader market indices.

Shiller's work on the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, which is based on historical data going back to 1871, gained significant attention, particularly around the dot-com bubble of the late 1990s and early 2000s, when he correctly identified that equity markets were significantly overvalued. The data series for the CAPE ratio is maintained and regularly updated, providing a historical context for market analysis.

Key Takeaways

• The Adjusted Annualized P/E Ratio, also known as the CAPE ratio or Shiller P/E, divides the current real stock price by the average of 10 years of inflation-adjusted earnings.
• It is designed to smooth out the impact of business cycles on corporate earnings, offering a more stable valuation metric than the standard price-to-earnings ratio.
• Higher CAPE values have historically been associated with lower long-term future stock market returns, and lower values with higher returns.
• The ratio is primarily used for long-term investing analysis, helping to assess whether an entire market, or a broad index, is overvalued or undervalued.
• Criticisms include its failure to account for changes in accounting standards or prevailing interest rates.

Formula and Calculation

The formula for the Adjusted Annualized P/E Ratio (CAPE) is as follows:

To calculate the Adjusted Annualized P/E Ratio:

1. Obtain historical earnings per share (EPS) data: Gather the annual EPS for the past ten years for the stock or index in question.
2. Adjust for inflation: Inflate each year's EPS to the present day using the Consumer Price Index (CPI) or another relevant inflation adjustment factor. This creates "real" earnings.
3. Calculate the 10-year average: Sum the inflation-adjusted EPS for the ten years and divide by ten.
4. Determine the current real price: Take the current price of the stock or index and adjust it for inflation if necessary to ensure it's comparable to the real earnings. For market indices like the S&P 500, the "real price" is typically the current nominal price.
5. Divide the current real price by the average real earnings: The result is the Adjusted Annualized P/E Ratio.

Interpreting the Adjusted Annualized P/E Ratio

The Adjusted Annualized P/E Ratio provides a perspective on stock market valuation that aims to be less distorted by short-term economic fluctuations or unusual earnings events. A high CAPE ratio suggests that the market, or a particular stock, is expensive relative to its long-term average earnings. Conversely, a low CAPE ratio may indicate that the market is undervalued.

Historically, a higher CAPE ratio has often preceded periods of lower long-term investing returns for the stock market, while a lower CAPE ratio has often preceded periods of higher long-term returns⁷. However, it is important to consider the ratio within its historical context and alongside other economic indicators and valuation metrics.

Hypothetical Example

Consider a hypothetical market index, "DiversiFund 500," with a current price of $5,000. Let's assume its inflation-adjusted earnings per share (EPS) for the past ten years are as follows:

1. Sum of 10-year inflation-adjusted EPS:
   $180 + $190 + $170 + $200 + $210 + $195 + $205 + $185 + $220 + $215 = $1,970

2. 10-year average inflation-adjusted EPS:
   $1,970 / 10 = $197

3. Calculate the Adjusted Annualized P/E Ratio:
   $5,000 / $197 ≈ 25.38

In this hypothetical example, the DiversiFund 500 has an Adjusted Annualized P/E Ratio of approximately 25.38. An investor would then compare this value to the historical average CAPE ratio for the DiversiFund 500 to gauge its current valuation.

Practical Applications

The Adjusted Annualized P/E Ratio is widely used by investors, strategists, and economists primarily for macro-level investment analysis and strategic asset allocation. Its key applications include:

• Market Timing (Long-Term): While not a precise timing tool, a very high or very low CAPE ratio can inform long-term allocation decisions between equity markets and other asset classes. For instance, a historically high CAPE might suggest reducing equity exposure, anticipating lower returns over the next decade or two.
  ⁶* Forecasting Long-Term Returns: Research by Shiller and others has shown a historical inverse correlation between the starting CAPE ratio and subsequent long-term stock market returns. ⁵This makes it a valuable metric for setting realistic return expectations.
• Cross-Market Comparisons: The Adjusted Annualized P/E Ratio can be applied to different national or regional indices, allowing for comparisons of relative valuations across global markets.

Historical data for the S&P 500 CAPE ratio, for example, is readily available and frequently updated by various financial data providers, reflecting its significance in market analysis.
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Limitations and Criticisms

Despite its widespread use, the Adjusted Annualized P/E Ratio has faced several criticisms:

• Relevance in Changing Economic Regimes: Some critics argue that the CAPE ratio's predictive power may diminish in environments with persistently low interest rates. Low interest rates can justify higher equity valuations because future earnings are discounted at a lower rate, making them more valuable today. Research suggests that the traditional CAPE might not fully account for these shifts, leading to proposed modifications.
  ³* Accounting Standard Changes: The calculation of earnings has evolved over time due to changes in generally accepted accounting principles (GAAP) and the increasing prevalence of non-GAAP earnings adjustments by companies. Some argue that historical earnings used in the CAPE calculation might not be entirely comparable to current earnings, potentially making the ratio appear higher than it otherwise would. ²The Securities and Exchange Commission (SEC) has also expressed concerns and taken enforcement actions regarding companies' "earnings management" practices, which can affect the comparability and reliability of reported earnings.
  ¹* Lack of Actionable Short-Term Signals: The Adjusted Annualized P/E Ratio is a long-term indicator and is not designed for short-term market timing. Markets can remain "overvalued" or "undervalued" by the CAPE for extended periods, making it less useful for tactical allocation decisions.
• Ignoring Risk-Free Rates: The CAPE ratio does not explicitly incorporate the prevailing risk-free rate of return, which can influence how investors value equities relative to other investments like bonds.

Adjusted Annualized P/E Ratio vs. Price-to-Earnings (P/E) Ratio

The Adjusted Annualized P/E Ratio (CAPE) and the price-to-earnings ratio (P/E) are both valuation metrics, but they differ significantly in their calculation and intended use.

The primary distinction lies in the earnings component. While the P/E ratio uses a company's or index's most recent earnings per share, which can be heavily influenced by the current point in the business cycles, the Adjusted Annualized P/E Ratio averages earnings over a longer period (typically ten years) and adjusts for inflation adjustment. This smoothing makes the CAPE ratio a more robust indicator for long-term risk assessment and understanding broad market valuation trends, whereas the standard P/E ratio provides a more immediate snapshot of current profitability relative to price.

FAQs

What does a high Adjusted Annualized P/E Ratio mean?

A high Adjusted Annualized P/E Ratio suggests that the stock market, or a specific stock, is expensive relative to its long-term average earnings. Historically, periods of very high CAPE ratios have been followed by lower long-term investment returns over the subsequent decade or two.

Can the Adjusted Annualized P/E Ratio predict market crashes?

The Adjusted Annualized P/E Ratio is not intended as a short-term market timing tool or a predictor of impending market crashes. While high CAPE values have been observed before significant market declines, the exact timing of such events cannot be predicted by this ratio alone, and markets can remain "overvalued" for extended periods. It is more suited for understanding long-term market efficiency.

Why does the Adjusted Annualized P/E Ratio adjust for inflation?

Adjusting for inflation adjustment ensures that historical earnings are comparable to current earnings in real terms. This accounts for the erosion of purchasing power over time, providing a more accurate and consistent basis for evaluating a company's or market's underlying profitability across different economic periods.

Is the Adjusted Annualized P/E Ratio used for individual stocks or market indices?

While it can theoretically be applied to individual stocks, the Adjusted Annualized P/E Ratio is most commonly and effectively used for broad market indices, such as the S&P 500, to assess overall equity valuation trends and potential long-term stock market returns. Its purpose is to smooth out business cycles that affect aggregate corporate earnings.