Adjusted economic p e ratio

What Is Adjusted Economic P/E Ratio?

The Adjusted Economic P/E Ratio is a sophisticated valuation metric used in investment analysis that refines the traditional price-to-earnings ratio by accounting for the cyclical nature of corporate earnings and the impact of inflation. It falls under the broader financial category of valuation metrics. Unlike simple P/E ratios that use a single year's earnings per share, this adjusted measure smooths out earnings over a longer period, typically a decade, and often considers "economic earnings" rather than purely reported accounting earnings. This adjustment aims to provide a more stable and accurate reflection of a company's or market's underlying earning power, less distorted by short-term economic fluctuations or accounting anomalies.

History and Origin

The concept behind adjusting earnings for cyclicality has roots in the work of value investors like Benjamin Graham and David Dodd, who advocated for smoothing a firm's earnings over several years (five to ten) to gain a clearer picture of its true earning power, recognizing that single-year earnings are too volatile. This idea was formalized and popularized by Yale University economics professor Robert J. Shiller and economist John Y. Campbell in their 1988 paper, "Stock Prices, Earnings, and Expected Dividends."¹⁹,¹⁸ Their research led to the development of the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, often referred to as the Shiller P/E or P/E 10 ratio. The CAPE ratio takes the current stock price and divides it by the average of ten years of inflation-adjusted earnings.,¹⁷ Shiller later highlighted its utility in assessing market valuations, notably before the dot-com bubble burst.¹⁶ The motivation behind such adjustments, particularly the "economic" aspect, is to move beyond standard GAAP (Generally Accepted Accounting Principles) figures, which were initially designed for debt investors, to capture the true cash flow available to equity investors.¹⁵,¹⁴

Key Takeaways

• The Adjusted Economic P/E Ratio refines the traditional price-to-earnings metric by using smoothed, inflation-adjusted earnings over a long period, typically 10 years.
• It aims to provide a more stable and less volatile valuation by mitigating the impact of business cycles.
• This ratio helps assess whether a stock or market index is overvalued or undervalued, particularly for long-term investors.
• It often implicitly or explicitly incorporates the concept of "economic earnings," which represent a truer measure of a company's profitability than reported accounting earnings.
• While a valuable tool, it should be used in conjunction with other financial statements and economic indicators for comprehensive analysis.

Formula and Calculation

The Adjusted Economic P/E Ratio, closely mirroring the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, is calculated by dividing the current market price of a stock or index by the average of its inflation-adjusted earnings per share over a specified long period, typically the past 10 years.

The formula can be expressed as:

Where:

• Current Market Price: The prevailing market price of the stock or the current value of the equity index.
• Average of 10-Year Inflation-Adjusted Earnings per Share: This is the arithmetic mean of the earnings per share (EPS) for the past 10 years, with each year's EPS value adjusted for inflation to present it in real terms. This smoothing process accounts for the cyclical nature of corporate profits, which can be significantly affected by economic booms and busts.

For instance, if a company's nominal earnings were $2.00 in Year 1 and inflation was 3%, the inflation-adjusted earnings would be calculated accordingly. This real earnings figure is then averaged with the real earnings of the preceding nine years to form the denominator.

Interpreting the Adjusted Economic P/E Ratio

Interpreting the Adjusted Economic P/E Ratio involves comparing its current value to its historical average or to the ratios of other comparable assets or market indices. A high Adjusted Economic P/E Ratio may suggest that a stock or market is overvalued relative to its long-term earnings potential, implying lower future return on investment. Conversely, a low ratio could indicate undervaluation and potentially higher future returns.¹³

For example, if the historical average of a market's Adjusted Economic P/E Ratio is around 20, and the current reading is 30, it suggests that investors are paying a significant premium for each dollar of long-term adjusted earnings. This could reflect strong market sentiment, but also heightened risk. It's crucial to remember that what constitutes "high" or "low" can vary over time due to shifts in market efficiency, interest rates, and other macroeconomic factors. Therefore, this ratio should be assessed within its historical context and alongside other fundamental analysis metrics.

Hypothetical Example

Consider a hypothetical market index, "DiversiFund 500," with a current value of 5,000 points. To calculate its Adjusted Economic P/E Ratio, we gather the inflation-adjusted earnings per share (EPS) for the index over the past 10 years:

• Year 1: $150
• Year 2: $145
• Year 3: $160
• Year 4: $170
• Year 5: $155
• Year 6: $165
• Year 7: $180
• Year 8: $175
• Year 9: $190
• Year 10: $185

First, sum these inflation-adjusted earnings:
$150 + $145 + $160 + $170 + $155 + $165 + $180 + $175 + $190 + $185 = $1,675

Next, calculate the 10-year average:
$1,675 / 10 = $167.50

Now, compute the Adjusted Economic P/E Ratio:

If the historical average Adjusted Economic P/E Ratio for the DiversiFund 500 is 22, then a current reading of 29.85 suggests that the index is trading at a higher valuation than its historical norm, indicating that investors are paying a premium for these long-term adjusted earnings. This insight could inform an investor's asset allocation decisions.

Practical Applications

The Adjusted Economic P/E Ratio serves as a critical tool for long-term investors and strategists in evaluating broad equity markets and individual securities. It is particularly useful for:

• Long-Term Market Valuation: The ratio helps investors gauge whether an entire stock market, such as the S&P 500, is overvalued or undervalued from a historical perspective. Robert Shiller's data, which extends back to 1871, provides a robust historical context for this analysis.¹²
• Forecasting Future Returns: A higher Adjusted Economic P/E Ratio has historically been associated with lower long-term future returns, and vice versa. While not a precise market timing tool, it offers a probabilistic understanding of potential returns over decades.,¹¹
• Strategic Asset Allocation: Investment firms and institutional investors use this ratio to inform their strategic asset allocation decisions, adjusting portfolio exposure to equities based on market-wide valuations.
• Identifying Value vs. Growth: While less common for individual stocks, the principles of smoothing earnings can help identify if a company's high or low traditional P/E is due to temporary cyclical factors or reflects true long-term growth prospects.
• Academic Research: The Adjusted Economic P/E Ratio, particularly the CAPE ratio, is a widely studied metric in academic finance for its predictive power regarding long-term stock market performance. John Y. Campbell and Robert J. Shiller's work on this topic has been foundational.¹⁰

Limitations and Criticisms

While the Adjusted Economic P/E Ratio offers a more nuanced view than a simple P/E, it is not without its limitations and criticisms:

• Not a Market Timing Tool: A high Adjusted Economic P/E Ratio does not signal an imminent market crash. Markets can remain "expensive" for extended periods.⁹,⁸ Critics, including Research Affiliates, have pointed out its unreliability in picking market peaks and troughs.⁷,⁶
• Changing Accounting Practices: The way corporate earnings are calculated under GAAP has evolved over time. This can make historical comparisons challenging, as the definition of earnings used in the past might not be directly comparable to current figures. For instance, the increased prevalence of stock buybacks over dividends can affect how earnings per share translate to investor returns.⁵
• Ignores Growth Potential: The ratio is inherently backward-looking, relying on historical earnings. It does not explicitly account for significant changes in a company's or economy's future growth prospects or the impact of intangible assets, which are increasingly important for modern technology companies.⁴
• Does Not Account for Interest Rates: Low interest rates can justify higher valuation multiples, as future earnings are discounted at a lower rate. The Adjusted Economic P/E Ratio itself does not directly incorporate the prevailing interest rate environment, which can influence fair valuation levels.
• Sector-Specific Differences: Applying a universal benchmark for the Adjusted Economic P/E Ratio across all industries might be misleading, as different sectors inherently have varying growth profiles and capital structures.³,² High-growth sectors, for example, might consistently trade at higher multiples.
• Focus on Economic Earnings: While aiming for "economic earnings" can be beneficial, the precise adjustments needed to derive these from reported earnings can be subjective and vary between different methodologies.¹

Ultimately, investors should consider these drawbacks and use the Adjusted Economic P/E Ratio as one piece of a broader investment analysis framework, combining it with other quantitative and qualitative factors.

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

The terms "Adjusted Economic P/E Ratio" and "Cyclically Adjusted Price-to-Earnings (CAPE) Ratio" are often used interchangeably or refer to very similar concepts in the realm of stock valuation. The CAPE ratio, popularized by Robert Shiller, is the most widely recognized form of a cyclically adjusted P/E. It specifically uses the average of 10 years of inflation-adjusted real earnings in its denominator to smooth out the effects of economic cycles on corporate profitability.,

The "Adjusted Economic P/E Ratio," as discussed in this article, emphasizes the foundational idea of adjusting for economic fluctuations and potentially relying on a concept of "economic earnings" rather than solely reported accounting earnings. While the CAPE ratio explicitly accounts for cyclicality and inflation, the "economic" aspect in the "Adjusted Economic P/E Ratio" can imply a deeper look into the true profitability and cash flow to shareholders, beyond what traditional accounting statements might show. In essence, the CAPE ratio is a specific and well-defined methodology for achieving an adjusted economic P/E, making it the most prominent practical application of the broader concept. Both aim to overcome the limitations of the simple price-to-earnings ratio, which can be highly volatile due to short-term earnings fluctuations.

FAQs

What makes the Adjusted Economic P/E Ratio different from a standard P/E ratio?
A standard price-to-earnings ratio typically uses a company's earnings from the most recent 12 months. The Adjusted Economic P/E Ratio (like the CAPE ratio) uses an average of inflation-adjusted earnings over a much longer period, usually 10 years. This longer average smooths out the ups and downs of business cycles and provides a more stable and representative measure of long-term earning power.

Is a high Adjusted Economic P/E Ratio always bad?
Not necessarily. While a high Adjusted Economic P/E Ratio historically suggests lower long-term future returns, it does not predict immediate market downturns. Markets can trade at elevated valuations for extended periods. It indicates that investors are paying a premium for earnings, which could be justified by factors like exceptionally low interest rates or expectations of future high capital gains and growth, though such justifications are debated.

Can the Adjusted Economic P/E Ratio be used for individual stocks?
While the Adjusted Economic P/E Ratio (or CAPE) is most commonly applied to broad market indices like the S&P 500, its underlying principle of smoothing earnings can be adapted for individual stocks, especially those in cyclical industries. However, company-specific factors and future growth prospects are often more influential for single-stock stock valuation.