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What Is the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio?

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio is a valuation measure used to assess whether a stock market or individual stock is undervalued or overvalued, belonging to the broader category of Valuation Metrics. Also known as the Shiller P/E ratio or P/E 10 ratio, the CAPE ratio accounts for the cyclical nature of corporate earnings by averaging inflation-adjusted earnings per share over the past ten years. This smoothing helps to mitigate the impact of short-term economic fluctuations, providing a more stable and comprehensive view of a company's or market's true earning power over a full business cycle. The use of the CAPE ratio allows investors to look beyond a single year's potentially volatile earnings, offering a longer-term perspective on investment opportunities within the stock market.

History and Origin

The concept behind the Cyclically Adjusted Price-to-Earnings (CAPE) ratio draws inspiration from value investing pioneers Benjamin Graham and David Dodd, who advocated for smoothing earnings over multiple years to gain a clearer picture of a company's sustainable profitability. However, the CAPE ratio, in its popularized form, was developed and extensively researched by economist Robert J. Shiller of Yale University and John Y. Campbell. Shiller widely disseminated the ratio, particularly through his book "Irrational Exuberance," and made the underlying data publicly available11. The ratio gained significant attention when Shiller used it to highlight what he perceived as overvaluations in the U.S. stock market prior to the dot-com bubble burst in the early 2000s and again before the 2008 financial crisis. His work demonstrated a strong inverse correlation between the CAPE ratio and subsequent long-term equity returns over periods of 10 to 20 years10.

Key Takeaways

  • The Cyclically Adjusted Price-to-Earnings (CAPE) ratio is a long-term valuation metric that smooths out cyclical fluctuations in earnings.
  • It is calculated by dividing the current stock price by the average of ten years of inflation-adjusted earnings per share.
  • A higher CAPE ratio generally suggests lower expected long-term returns, while a lower CAPE ratio may indicate higher expected long-term returns.
  • The CAPE ratio is most commonly applied to broad market indices, such as the S&P 500, to gauge overall market valuation.
  • Critics note limitations, including changes in accounting standards, share buyback effects, and the omission of interest rates in its standard calculation.

Formula and Calculation

The formula for the Cyclically Adjusted Price-to-Earnings (CAPE) ratio is as follows:

CAPE Ratio=Current Real Price10-Year Average Real Earnings per Share (EPS)\text{CAPE Ratio} = \frac{\text{Current Real Price}}{\text{10-Year Average Real Earnings per Share (EPS)}}

Where:

  • Current Real Price: The current market price of the stock or index, adjusted for inflation using a price index like the Consumer Price Index (CPI).
  • 10-Year Average Real Earnings Per Share (EPS): The average of the annual earnings per share over the past ten years, with each year's earnings adjusted for inflation to present-day values.

To calculate the CAPE ratio for an index like the S&P 500, one would typically:

  1. Gather the monthly closing prices for the index.
  2. Obtain the annual reported earnings for the index over the past ten years.
  3. Adjust both the current price and each of the ten annual earnings figures for inflation using a reliable inflation index, such as the CPI from the Federal Reserve Bank of Minneapolis9.
  4. Calculate the average of the ten inflation-adjusted earnings figures.
  5. Divide the current inflation-adjusted price by this ten-year average of inflation-adjusted earnings.

Interpreting the CAPE Ratio

Interpreting the Cyclically Adjusted Price-to-Earnings (CAPE) ratio involves comparing its current value to its historical average. A CAPE ratio significantly above its long-term average may suggest that the market or a particular security is overvalued, implying lower future long-term equity returns. Conversely, a CAPE ratio below its historical average might indicate undervaluation, suggesting potentially higher long-term returns. For instance, if the historical average CAPE for a market index is around 17, and the current CAPE stands at 30, it could signal that the market is expensive relative to its long-term earnings potential.

However, interpretation should not be rigid. Factors such as prevailing risk-free rate and economic growth prospects can influence what constitutes a "normal" CAPE level. Lower interest rates, for example, might justify a higher CAPE ratio as future earnings are discounted at a lower rate, making them more valuable today. It is important to consider the overall economic environment and other valuation metrics alongside the CAPE ratio.

Hypothetical Example

Consider an investor evaluating the hypothetical "Global Diversified Index" using the Cyclically Adjusted Price-to-Earnings (CAPE) ratio.

Scenario:

  • Current Price of Global Diversified Index: 5,000 units
  • Inflation-adjusted annual earnings per share (EPS) for the past 10 years:
    • Year 1: 150
    • Year 2: 170
    • Year 3: 160
    • Year 4: 180
    • Year 5: 190
    • Year 6: 140 (during a recession)
    • Year 7: 160
    • Year 8: 200
    • Year 9: 210
    • Year 10: 220

Step-by-step Calculation:

  1. Sum of 10-Year Average Real EPS:
    (150 + 170 + 160 + 180 + 190 + 140 + 160 + 200 + 210 + 220 = 1780)

  2. Average Real EPS:
    (1780 / 10 = 178)

  3. Calculate CAPE Ratio:
    ( \text{CAPE Ratio} = \frac{5000}{178} \approx 28.09 )

In this hypothetical example, the Global Diversified Index has a CAPE ratio of approximately 28.09. If the historical average CAPE for this index is, for instance, 20, then the current reading of 28.09 might suggest that the index is currently trading at a higher valuation relative to its long-term earnings, signaling potential overvaluation.

Practical Applications

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio serves as a significant tool in several areas of finance:

  • Long-Term Market Valuation: The primary application of the CAPE ratio is to assess the long-term valuation of broad stock market indices. It helps investors gauge whether the market as a whole is cheap or expensive over a full business cycle, rather than being swayed by temporary spikes or dips in earnings.
  • Asset Allocation Decisions: Portfolio managers and institutional investors often use the CAPE ratio to inform their strategic asset allocation. A high CAPE ratio in equities might encourage a shift towards other asset classes, such as bonds or real estate, in anticipation of lower future stock returns. Conversely, a low CAPE could signal an opportune time to increase equity exposure.
  • Predicting Future Returns: Research, notably by Robert Shiller, has indicated that the CAPE ratio has predictive power for long-term (10-20 year) market returns, with higher CAPE values generally correlating with lower subsequent returns and vice-versa8. This makes it a valuable metric for investors with a long-term investment horizon.
  • Academic Research and Economic Analysis: Economists and financial researchers frequently employ the CAPE ratio in studies related to market efficiency, asset pricing, and macro-financial stability. It provides a standardized measure for comparing market valuations across different historical periods and global markets7. Its data, available from sources like Robert Shiller's website, are crucial for such analyses6.

Limitations and Criticisms

Despite its widespread recognition and utility, the Cyclically Adjusted Price-to-Earnings (CAPE) ratio faces several limitations and criticisms:

  • Backward-Looking Nature: The CAPE ratio relies on historical earnings data, making it inherently backward-looking rather than forward-looking. Critics argue that past earnings may not be an accurate predictor of future profitability, especially in rapidly evolving industries or during periods of significant economic or technological change.
  • Changes in Accounting Standards: Over time, generally accepted accounting principles (GAAP) have undergone significant changes. This can make the comparison of reported earnings from different historical periods inconsistent, potentially distorting the CAPE ratio's accuracy when used for very long historical comparisons5. Some suggest that these accounting changes may make the current CAPE ratio appear artificially high compared to past periods.
  • Impact of Share Buybacks: The increasing prevalence of share buybacks as a method for companies to return capital to shareholders, as opposed to dividends, can affect the earnings per share (EPS) denominator of the CAPE ratio. Buybacks reduce the number of outstanding shares, which can artificially inflate EPS and, consequently, the CAPE ratio, making it appear higher without a corresponding increase in underlying corporate profitability4.
  • Exclusion of Interest Rates: The standard CAPE ratio does not explicitly account for prevailing interest rates or the risk-free rate. Low interest rates can justify higher equity valuations, as future earnings are discounted at a lower rate. Omitting this factor can lead to an overestimation of market overvaluation during periods of sustained low interest rates3,2.
  • Limited Utility for Market Timing: While useful for long-term return forecasting, the CAPE ratio is generally not considered an effective tool for short-term market timing. It can remain elevated or depressed for extended periods before a significant market correction or rally occurs, making it difficult to use for precise entry or exit points1.

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

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio and the traditional Price-to-Earnings (P/E) Ratio are both valuation metrics used to assess a company's or market's share price relative to its earnings. However, a key distinction lies in how they handle the earnings component.

The standard P/E ratio uses a company's or market's trailing 12-month earnings per share. This makes it highly sensitive to short-term fluctuations in profitability. For example, a temporary surge in earnings can make a stock appear cheap based on its P/E ratio, while a recession might cause earnings to drop sharply, making the P/E ratio soar and suggesting overvaluation, even if the price has fallen.

In contrast, the CAPE ratio addresses this volatility by using the average of ten years of inflation-adjusted earnings. By smoothing earnings over a full business cycle, the CAPE ratio provides a more stable and representative measure of a company's or market's underlying earning power. This stability makes the CAPE ratio particularly useful for long-term investors and for assessing broader market trends, as it removes the noise caused by short-term economic expansions and contractions. The P/E ratio, while simpler and more immediate, is less suitable for identifying long-term valuation extremes because it is more susceptible to cyclical shifts in corporate profits.

FAQs

What does a high CAPE ratio signify?

A high Cyclically Adjusted Price-to-Earnings (CAPE) ratio generally suggests that the market or a particular investment is expensive relative to its long-term average earnings. Historically, elevated CAPE ratios have been associated with lower long-term equity returns in the subsequent 10 to 20 years.

Is the CAPE ratio applicable to individual stocks?

While the CAPE ratio is most commonly applied to broad market indices like the S&P 500, it can theoretically be calculated for individual stocks. However, its effectiveness for single securities may be limited due to individual company-specific factors and the dynamic nature of their business cycles, which may not align with a fixed 10-year period.

How does inflation affect the CAPE ratio?

Inflation is directly accounted for in the CAPE ratio calculation. Both the current price and the ten years of historical earnings per share (EPS) are adjusted to real (inflation-adjusted) terms using a consumer price index (CPI). This ensures that changes in the ratio reflect actual changes in valuation rather than just the erosion of purchasing power.

What is a "normal" CAPE ratio?

There isn't a universally agreed-upon "normal" CAPE ratio, as it can vary based on historical periods, different markets, and prevailing economic conditions. However, for the U.S. stock market (S&P 500), the historical average CAPE ratio has typically hovered around 16-17. Deviations from this average are often used to gauge potential over or undervaluation.

Can the CAPE ratio predict market crashes?

The CAPE ratio is not designed as a precise market timing tool to predict imminent market correction or crashes. While high CAPE values have preceded significant market downturns in the past (e.g., 1929, 2000, 2007), it can remain elevated for extended periods. Its primary utility lies in forecasting long-term, not short-term, returns.