Adjusted composite p e ratio

What Is Adjusted Composite P/E Ratio?

The Adjusted Composite P/E Ratio, more widely known as the Cyclically Adjusted Price-to-Earnings (CAPE) ratio or Shiller P/E, is a valuation measure used in equity valuation to assess whether a stock market or a particular stock index is undervalued or overvalued. This financial metric smooths out fluctuations in earnings per share (EPS) that occur over different periods of an economic cycle by averaging earnings over a long period, typically ten years, and adjusting them for inflation. By doing so, the Adjusted Composite P/E Ratio provides a more stable and less volatile view of a market's earning power, offering a clearer signal about its long-term financial performance.

History and Origin

The concept of smoothing earnings to get a more accurate picture of a company's earning power has roots in the work of value investing pioneers Benjamin Graham and David Dodd, who advocated for using five- to ten-year average earnings in their classic text Security Analysis. They observed that single-year earnings were too volatile to reflect a firm's true earnings per share.

The modern iteration of the Adjusted Composite P/E Ratio was popularized by American economist and Nobel Laureate Robert J. Shiller. In a 1988 paper with John Y. Campbell, Shiller concluded that a long moving average of real earnings helps forecast future real dividends and, by extension, stock returns¹⁸. Shiller specifically developed and advocated for the 10-year, inflation-adjusted version, applying it primarily to the S&P 500 index to gauge aggregate market valuation. His work gained significant attention during the dot-com bubble in the late 1990s, when he correctly argued that equity markets were highly overvalued based on this metric¹⁷. Shiller later received the Nobel Prize in Economics in 2013, partly in recognition of his research on the long-horizon importance of valuation¹⁶. Historical data for the CAPE ratio is publicly available on Robert Shiller's website.

Key Takeaways

• The Adjusted Composite P/E Ratio (CAPE) averages ten years of inflation-adjusted earnings to smooth out economic cycle effects.
• It is primarily used to assess long-term market valuation and potential future equity returns.
• A higher CAPE ratio generally suggests lower expected long-term returns, while a lower ratio may indicate higher expected returns.
• This ratio helps investors look beyond short-term fluctuations in corporate profits to understand underlying market valuation.
• It is most commonly applied to broad market indices like the S&P 500.

Formula and Calculation

The formula for the Adjusted Composite P/E Ratio is:

Where:

• Current Market Price of Index: The current value of the stock index, such as the S&P 500.
• Average of Last 10 Years' Real (Inflation-Adjusted) Earnings Per Share: The arithmetic average of the index's earnings per share over the past ten years, with each year's earnings adjusted for inflation to constant dollars. This smoothing process accounts for business cycles, which can significantly distort single-year P/E ratios.

Interpreting the Adjusted Composite P/E Ratio

Interpreting the Adjusted Composite P/E Ratio involves comparing its current value to its historical average. A high Adjusted Composite P/E Ratio suggests that the market, or a specific stock index, is expensive relative to its long-term average earnings. Conversely, a low Adjusted Composite P/E Ratio may indicate that the market is undervalued.

For example, the historical average CAPE ratio for the S&P 500 has typically ranged between 15 and 16. Readings significantly above this average, such as those seen before the 1929 market crash, the dot-com bubble in 2000, and the 2007-2008 financial crisis, have often preceded periods of lower future equity returns¹⁴, ¹⁵. Conversely, very low CAPE ratios, like those observed in the 1970s, have historically been followed by periods of strong market performance. This metric is considered a tool for long-term investing insights, typically over timescales of 10 to 20 years, rather than a short-term market timing indicator¹³.

Hypothetical Example

Consider a hypothetical stock market index.

1. Current Market Price: Assume the current market price of the "Diversification Index" is 2,000 points.

2. Historical Earnings: The annual earnings per share (EPS) for the Diversification Index over the last ten years, adjusted for inflation, are:

   • Year 10: $100
   • Year 9: $95
   • Year 8: $80
   • Year 7: $70
   • Year 6: $65
   • Year 5: $75
   • Year 4: $85
   • Year 3: $90
   • Year 2: $110
   • Year 1: $105

3. Calculate Average Real Earnings:
   Sum of earnings = $100 + $95 + $80 + $70 + $65 + $75 + $85 + $90 + $110 + $105 = $875
   Average real earnings = $875 / 10 = $87.50

4. Calculate Adjusted Composite P/E Ratio:
   Adjusted Composite P/E Ratio = Current Market Price / Average Real Earnings
   Adjusted Composite P/E Ratio = 2,000 / 87.50 $\approx$ 22.86

In this hypothetical example, an Adjusted Composite P/E Ratio of approximately 22.86 would be compared against the index's historical average CAPE to determine if it is currently overvalued or undervalued.

Practical Applications

The Adjusted Composite P/E Ratio is a significant tool in fundamental analysis for assessing market-wide valuation and long-term investment prospects. Its primary applications include:

• Long-Term Market Forecasting: Investors and economists use the CAPE ratio to project potential equity returns over extended periods. High CAPE readings have historically been associated with lower subsequent returns over the next decade or two, and vice versa¹².
• Asset Allocation Decisions: Portfolio managers may use the CAPE ratio to inform their strategic asset allocation decisions. If the market's CAPE is significantly high, they might consider reducing exposure to equities in favor of other asset classes like bonds or real estate, expecting lower returns from stocks.
• Academic Research: The ratio is a widely cited metric in academic studies on market efficiency and predictability.
• Evaluating Market Sentiment: While not a perfect indicator, a persistently high Adjusted Composite P/E Ratio can reflect excessive investor sentiment or "irrational exuberance" within the stock market, where prices are driven up faster than underlying corporate profits can support. For instance, recent analyses by news organizations frequently cite the S&P 500's P/E ratios, noting that current valuations are higher than historical averages, suggesting a potentially expensive market¹¹.

Limitations and Criticisms

Despite its widespread use, the Adjusted Composite P/E Ratio faces several limitations and criticisms:

• Not a Market Timing Tool: While predictive of long-term returns, the CAPE ratio is not designed for precise market timing. A high CAPE does not guarantee an imminent market downturn, nor does a low CAPE signal an immediate rally⁹, ¹⁰. Markets can remain overvalued or undervalued for extended periods.
• Changes in Accounting Standards: Critics argue that changes in accounting rules, particularly in the 1990s, may have affected reported earnings per share, potentially distorting the historical comparability of the CAPE ratio. Some suggest that contemporary earnings might be understated compared to historical periods, making the current CAPE appear artificially high⁸.
• Influence of Interest Rates and Discount Rates: The ratio does not explicitly account for prevailing interest rates. A lower discount rate environment, such as one with persistently low real interest rates, might justify a higher P/E ratio, including the CAPE, as future earnings are discounted at a lower rate⁷. Ignoring this context can lead to misinterpretations of the ratio's implications.
• Profit Margins and Corporate Profits: Current high corporate profits and profit margins can elevate the denominator of the P/E ratio, making current valuations seem more reasonable than they might be if profit margins mean-revert to historical averages⁶. Some argue that a significant portion of recent economic growth has gone to corporate profits rather than wages, which could influence the level of the CAPE⁵.
• Compositional Changes: The composition of market indices, like the S&P 500, changes over time. The growing influence of high-growth technology companies with different earnings profiles might affect the interpretability of the aggregate CAPE ratio compared to historical periods⁴.

Leading financial research firms, such as Research Affiliates, frequently publish analyses addressing these criticisms, often concluding that while the CAPE has limitations, it remains a powerful predictor of long-term market returns², ³.

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

The Adjusted Composite P/E Ratio fundamentally differs from the traditional price-to-earnings ratio primarily in its treatment of earnings. The standard P/E ratio typically uses a company's or index's trailing 12-month earnings per share (trailing P/E) or forecasted next 12-month earnings (forward P/E) as its denominator. This makes the traditional P/E highly susceptible to short-term fluctuations in earnings due to business cycles, one-off events, or accounting adjustments.

In contrast, the Adjusted Composite P/E Ratio utilizes an average of ten years of inflation-adjusted earnings. This averaging process smooths out the peaks and troughs of economic cycles, providing a more normalized view of a company's or market's underlying earning power. While a traditional P/E ratio offers a snapshot of current or near-term valuation, the Adjusted Composite P/E Ratio is designed to provide a more stable and reliable indicator for assessing long-term investing prospects and identifying periods of broad market over or undervaluation. The stability of the CAPE ratio makes it a better tool for historical comparisons across different economic regimes than the more volatile traditional P/E.

FAQs

What does a high Adjusted Composite P/E Ratio suggest?

A high Adjusted Composite P/E Ratio suggests that the stock market or a specific stock index is currently overvalued relative to its long-term, inflation-adjusted earnings history. Historically, high CAPE readings have been associated with lower future equity returns over the subsequent 10 to 20 years.

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

While high Adjusted Composite P/E Ratio values have historically preceded major market downturns (such as those before 1929, 2000, and 2008), it is not a precise market timing tool and cannot predict exactly when a crash will occur¹. Markets can remain overvalued for extended periods. It is best used for long-term investing insights rather than short-term predictions.

How often is the Adjusted Composite P/E Ratio updated?

The Adjusted Composite P/E Ratio is typically calculated and updated monthly or quarterly, as it relies on broad economic data such as inflation and corporate profits, which are often released periodically by entities like the Bureau of Economic Analysis.

Is the Adjusted Composite P/E Ratio applicable to individual stocks?

While the underlying principle of smoothing earnings per share can be applied to individual stocks, the Adjusted Composite P/E Ratio, in its most common form (CAPE or Shiller P/E), is predominantly used for broad stock indexes like the S&P 500 rather than individual company shares. This is because its strength lies in smoothing out business cycles across a diverse set of companies.

Why adjust earnings for inflation when calculating the ratio?

Adjusting earnings per share for inflation ensures that the historical earnings data is comparable in "real" terms. Without inflation adjustment, nominal earnings from earlier periods would appear smaller relative to current nominal earnings, potentially distorting the true long-term valuation picture and making comparisons across different eras less meaningful.