Adjusted average p e ratio

What Is Adjusted Average P/E Ratio?

The Adjusted Average P/E Ratio, more commonly known as the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio or Shiller P/E, is a market valuation measure that uses real (inflation-adjusted) earnings per share over an extended period, typically 10 years, to smooth out fluctuations inherent in a Business Cycle. This Financial Ratios metric falls under the broader category of investment valuation and aims to provide a more stable and less volatile picture of a company's or market's earnings power than a simple Price-to-Earnings Ratio (P/E Ratio). By accounting for cyclical variations, the Adjusted Average P/E Ratio offers insights into potential long-term Stock Market returns and helps investors gauge whether a market is overvalued or undervalued.

History and Origin

The concept of smoothing earnings for valuation purposes is not new, with value investing pioneers Benjamin Graham and David Dodd advocating for the use of average earnings over several years in their seminal 1934 book, Security Analysis. They recognized that one-year earnings figures could be too volatile to accurately represent a firm's true earning power. The Adjusted Average P/E Ratio, however, was popularized and significantly advanced by Yale University professor Robert Shiller. In December 1996, Shiller and John Campbell presented research to the Federal Reserve suggesting that stock prices were rising much faster than corporate earnings. Their groundbreaking article, "Valuation Ratios and the Long-Run Stock Market Outlook," published in the winter of 1998, solidified the methodology. They smoothed Earnings Per Share for the S&P 500 by taking an average of real earnings over the preceding 10 years, extending back to 1872. The Adjusted Average P/E Ratio became a prominent tool for assessing market conditions, notably signaling potential overvaluation before the dot-com bubble burst in 2000 and the 2008 financial crisis. The historical data for the Shiller P/E is often cited, with values spanning back over a century.¹²

Key Takeaways

• The Adjusted Average P/E Ratio, or CAPE Ratio, averages inflation-adjusted earnings over a 10-year period to provide a smoother, more reliable valuation metric.
• It helps investors assess whether the overall market or a broad index is overvalued, undervalued, or fairly valued.
• Developed by Robert Shiller, this ratio aims to mitigate the volatility of traditional P/E ratios caused by short-term economic fluctuations and business cycles.
• Historically, higher Adjusted Average P/E Ratio values have been associated with lower long-term future equity returns.
• It is a long-term indicator and should be used in conjunction with other metrics for comprehensive Market Valuation.

Formula and Calculation

The formula for the Adjusted Average P/E Ratio (CAPE Ratio) is:

$\text{CAPE Ratio} = \frac{\text{Current Market Price}}{\text{Average of 10 Years of Inflation-Adjusted Earnings Per Share}}$

Where:

• Current Market Price represents the current price of a stock or, more commonly, a stock market index like the S&P 500.
• Average of 10 Years of Inflation-Adjusted Earnings Per Share is the average of the previous 10 years' Earnings Per Share for the index or company, adjusted for Inflation. This smoothing aims to account for the cyclical nature of corporate profits.

Interpreting the Adjusted Average P/E Ratio

Interpreting the Adjusted Average P/E Ratio involves comparing its current value to its historical average. A high Adjusted Average P/E Ratio relative to its historical mean may suggest that the market or a specific asset is overvalued, implying lower future long-term returns. Conversely, a low Adjusted Average P/E Ratio might indicate undervaluation and potentially higher future returns. For instance, the CAPE ratio for the S&P 500 has a long-term average, and its current level is often compared against this average to assess market sentiment.

This metric is primarily used for long-term Investment Strategy and not for short-term market timing. It provides context for evaluating overall market risk and potential Capital Appreciation over a decade or more. While a high ratio can signal an expensive market, it doesn't predict immediate market crashes. It suggests that future returns might be subdued compared to historical averages. Investors might consider adjusting their Portfolio Diversification based on the insights provided by this ratio.

Hypothetical Example

Consider a hypothetical stock market index, the "Diversified 500," with the following inflation-adjusted earnings per share (EPS) over the past 10 years:

• Year 1: $4.00
• Year 2: $4.50
• Year 3: $3.80
• Year 4: $4.20
• Year 5: $5.00
• Year 6: $4.70
• Year 7: $3.50 (during an Economic Recession)
• Year 8: $4.10
• Year 9: $5.20
• Year 10: $5.50

First, calculate the average of these 10 years of inflation-adjusted earnings:

$\text{Average EPS} = \frac{(4.00 + 4.50 + 3.80 + 4.20 + 5.00 + 4.70 + 3.50 + 4.10 + 5.20 + 5.50)}{10} = \frac{44.50}{10} = 4.45$

Now, assume the current market price of the Diversified 500 index is $1500.

Using the Adjusted Average P/E Ratio formula:

$\text{Adjusted Average P/E Ratio} = \frac{\text{Current Market Price}}{\text{Average of 10 Years of Inflation-Adjusted Earnings}} = \frac{1500}{4.45} \approx 337.08$

This hypothetical Adjusted Average P/E Ratio of approximately 337.08 would be compared against the index's historical average to determine if the market is currently overvalued or undervalued, providing a smoothed perspective less affected by any single year's earnings.

Practical Applications

The Adjusted Average P/E Ratio is primarily applied in macro-level economic and Market Valuation analysis. Investors, economists, and financial analysts use it to:

• Gauge long-term market prospects: It can signal whether current market valuations are sustainable or if they might portend lower future returns over extended periods (e.g., 10-20 years). For instance, the Federal Reserve Bank of San Francisco has discussed how extreme run-ups in the CAPE ratio can signal an overvalued Stock Market.¹¹
• Inform asset allocation decisions: A high Adjusted Average P/E Ratio might lead some investors to reduce their equity exposure and increase allocations to other asset classes, while a low ratio might suggest increasing equity exposure.
• Assess overall market sentiment: It provides a broader perspective than the more commonly used trailing or forward P/E ratios, which can be heavily influenced by short-term sentiment or temporary earnings fluctuations.
• Historical analysis: Researchers use the Adjusted Average P/E Ratio to study historical market cycles and the relationship between valuation and subsequent returns, demonstrating a strong inverse correlation between the CAPE ratio and S&P 500 returns over the subsequent 20 years.¹⁰

Limitations and Criticisms

Despite its widespread use, the Adjusted Average P/E Ratio has several limitations and has faced criticism:

• Backward-Looking Nature: The ratio relies on past earnings data, which may not always accurately reflect future prospects, especially in rapidly changing economic environments or for Growth Stocks.
• Changes in Accounting Standards: Critics argue that changes in generally accepted accounting principles (GAAP) over time can affect how earnings are calculated, potentially making historical comparisons misleading. This can skew the ratio, particularly when comparing current values to those from decades past.⁹
• Interest Rates and Macroeconomic Factors: Some argue that the Adjusted Average P/E Ratio does not adequately account for prevailing risk-free rates of return or other macroeconomic variables that can influence valuations. Low interest rates, for example, might justify a higher P/E ratio.
• Exclusion of Share Buybacks: The ratio may not fully capture the impact of share buybacks, which reduce the share count and can artificially inflate Earnings Per Share without a corresponding increase in underlying corporate earnings.⁸
• Sector Composition Changes: The composition of market indices changes over time, with new industries and companies gaining prominence. Comparing the Adjusted Average P/E Ratio of a tech-heavy market today to a market dominated by industrial companies a century ago may not be entirely "apples-to-apples."⁷
• Earnings Manipulation: Like the standard Price-to-Earnings Ratio, the "earnings" component can be subject to management's accounting choices, potentially misleading investors.⁶ It does not always reflect a company's true cash flow or consider its Return on Investment.⁵
• Lack of Predictive Power for Market Tops/Bottoms: While useful for long-term forecasting, the Adjusted Average P/E Ratio is not intended as a precise indicator of impending market crashes or short-term market timing.⁴ Focusing solely on this ratio for investment decisions could have led investors to miss significant market gains.³ The P/E ratio itself can be a misleading metric due to earnings volatility, accounting practices, and its inability to account for growth potential or intangible assets.²,,¹

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

The core difference between the Adjusted Average P/E Ratio (CAPE) and the standard Price-to-Earnings Ratio lies in how the "earnings" component is calculated.

The traditional Price-to-Earnings Ratio takes the current stock price and divides it by the most recent annual Earnings Per Share (trailing P/E) or projected future earnings (forward P/E). While simpler and widely used for comparing companies within the same industry, it can be highly volatile because a single year's earnings can be impacted by temporary factors like an Economic Recession, one-time gains, or accounting adjustments. The Adjusted Average P/E Ratio attempts to overcome this volatility by taking a multi-year average of real earnings, offering a more robust measure for long-term analysis and value investing perspectives.

FAQs

What does a high Adjusted Average P/E Ratio indicate?

A high Adjusted Average P/E Ratio suggests that the market or asset is currently valued above its long-term average earnings power, potentially implying lower long-term future returns. It does not necessarily mean a market crash is imminent but points to an elevated valuation from a historical perspective.

Is the Adjusted Average P/E Ratio suitable for individual stocks?

While theoretically applicable, the Adjusted Average P/E Ratio is less commonly used for individual stocks. Its primary utility lies in analyzing broad market indices like the Stock Market as a whole, where the smoothing effect of 10 years of earnings is more relevant to large-scale cyclical trends. Individual company earnings can be affected by specific company events or industry shifts, making a 10-year average less indicative of their immediate prospects than for a diversified index.

How does inflation affect the Adjusted Average P/E Ratio?

The "adjusted" part of the Adjusted Average P/E Ratio specifically refers to the adjustment for Inflation. By using inflation-adjusted (real) earnings, the ratio accounts for changes in the purchasing power of money over time, providing a more accurate comparison of earnings across different periods and ensuring consistency in the underlying value being measured.

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

No, the Adjusted Average P/E Ratio is not a market timing tool designed to predict crashes. While historically, very high Adjusted Average P/E Ratio levels have preceded periods of low or negative long-term returns, they do not pinpoint the exact timing of market downturns. It is a long-term valuation indicator that helps investors understand potential future return profiles over decades, not months or years. For short-term analysis, other Financial Ratios and indicators are typically used.