Adjusted benchmark p e ratio

What Is Adjusted Benchmark P/E Ratio?

The Adjusted Benchmark P/E Ratio, commonly known as the Cyclically Adjusted Price-to-Earnings (CAPE) ratio or Shiller P/E, is a valuation metric within the realm of financial analysis that assesses whether a stock market index, or a broad group of stocks, is overvalued or undervalued. Unlike the basic price-to-earnings (P/E) ratio, the Adjusted Benchmark P/E Ratio smooths out the volatile nature of corporate earnings over a long period, typically ten years. This approach provides a more stable and reliable indicator of market valuation by mitigating the effects of economic cycles and temporary fluctuations in profitability, offering a robust tool for fundamental analysis.

History and Origin

The Adjusted Benchmark P/E Ratio was popularized by Yale University professor and Nobel laureate Robert Shiller and his colleague John Campbell. Their seminal work aimed to address the inherent volatility of a single year's earnings when calculating the traditional price-to-earnings ratio. They proposed using a decade of average inflation-adjusted earnings to smooth out the impact of business cycles. This concept gained significant attention, particularly after Shiller and Campbell presented research to the Federal Reserve in December 1996, suggesting that stock prices were rising significantly faster than earnings, which proved prescient ahead of later market events. The methodology laid out by Shiller has since become a widely discussed measure in assessing the long-term prospects of the stock market.

Key Takeaways

• The Adjusted Benchmark P/E Ratio (CAPE) uses the average of 10 years of inflation-adjusted earnings to smooth out cyclical fluctuations.
• It provides a long-term perspective on market valuation, aiming to indicate whether a market is undervalued or overvalued.
• Historically, high CAPE values have been associated with lower long-term future returns, and low values with higher returns.
• The ratio is primarily applied to broad market indices like the S&P 500, rather than individual stocks.
• Critics note limitations such as its backward-looking nature and sensitivity to changes in accounting standards.

Formula and Calculation

The Adjusted Benchmark P/E Ratio is calculated by dividing the current real (inflation-adjusted) price of a stock index by the average of the index's real earnings per share (EPS) over the past ten years. This ten-year average helps to normalize earnings, removing the distortion caused by short-term economic booms or recessions.

The formula can be expressed as:

$\text{Adjusted Benchmark P/E Ratio (CAPE)} = \frac{\text{Current Real Stock Index Price}}{\text{10-Year Average Real Earnings Per Share}}$

Where:

• Current Real Stock Index Price: The current price of the stock market index, adjusted for inflation.
• 10-Year Average Real Earnings Per Share: The average of the annual earnings per share for the index over the last ten years, also adjusted for inflation.

To calculate the real values, nominal prices and earnings are typically deflated using a price index like the Consumer Price Index (CPI). Historical S&P 500 earnings data is readily available to perform such calculations¹¹, ¹².

Interpreting the Adjusted Benchmark P/E Ratio

Interpreting the Adjusted Benchmark P/E Ratio involves comparing its current value to its historical average. A high Adjusted Benchmark P/E Ratio suggests that the market is currently trading at a premium relative to its long-term average earnings, potentially indicating an overvalued market. Conversely, a low ratio might suggest that the market is undervalued. This ratio is often used by investors and analysts to gauge potential long-term returns. For example, higher-than-average CAPE values have historically implied lower-than-average long-term annual return on investment from equities over timescales of 10 to 20 years. This makes it a critical tool for long-term investing strategies, helping investors form expectations about future market performance rather than short-term price movements.

Hypothetical Example

Consider a hypothetical market index, "DiversiFund 500," with a current real price of 3,000. For the past 10 years, its inflation-adjusted annual earnings per share have been:

Year 1: 95
Year 2: 88
Year 3: 75
Year 4: 90
Year 5: 105
Year 6: 110
Year 7: 100
Year 8: 92
Year 9: 80
Year 10: 95

First, calculate the 10-year average real earnings per share:
(95 + 88 + 75 + 90 + 105 + 110 + 100 + 92 + 80 + 95) / 10 = 930 / 10 = 93

Now, apply the Adjusted Benchmark P/E Ratio formula:
$\text{Adjusted Benchmark P/E Ratio} = \frac{3,000}{93} \approx 32.26$

If the historical average Adjusted Benchmark P/E Ratio for the DiversiFund 500 is 20, a current ratio of 32.26 would suggest that the market is significantly overvalued compared to its historical norms. This kind of financial analysis helps investors assess the broad market's current valuation context.

Practical Applications

The Adjusted Benchmark P/E Ratio serves as a significant tool in various financial contexts, primarily for macro-level market assessment and strategic investment strategy. It is widely employed by institutional investors, economists, and academics to evaluate the overall stock market health and potential long-term returns. For instance, the Federal Reserve frequently reviews financial ratios like the P/E ratio in its Financial Stability Reports to gauge asset valuations and systemic risks⁹, ¹⁰.

Analysts use the Adjusted Benchmark P/E Ratio to inform decisions on asset allocation, determining whether to favor equities over other asset classes or adjust exposure based on perceived market over- or undervaluation. When the ratio is historically high, it may prompt a more cautious approach, while a low ratio might signal potential long-term opportunities. Recent market commentary often references the S&P 500's P/E ratios being above long-term averages, prompting discussions about whether current valuations can be sustained⁷, ⁸.

Limitations and Criticisms

While a powerful asset valuation tool, the Adjusted Benchmark P/E Ratio is not without its limitations and criticisms. A primary concern is its backward-looking nature; it relies on historical earnings, which may not accurately reflect future economic conditions or corporate profitability. Critics argue that changes in accounting standards over time can distort the comparison of current CAPE values to historical ones, making the ratio appear artificially high or low⁶. For example, Jeremy Siegel, a finance professor, has argued that changes in GAAP earnings calculations since the 1990s might make forecasts based on the CAPE ratio overly pessimistic.

Additionally, the Adjusted Benchmark P/E Ratio does not account for prevailing interest rates or the broader economic environment, which can significantly influence equity valuations. Low interest rates, for instance, might justify a higher P/E ratio. Furthermore, the ratio's effectiveness can be questioned in markets undergoing significant structural changes or those with heavy concentrations in fast-growing sectors like technology, where earnings growth rates might naturally command higher valuations⁴, ⁵. Relying solely on the Adjusted Benchmark P/E Ratio without considering other factors or employing proper risk management can lead to misleading¹, ²³