Adjusted indexed p e ratio: Meaning, Criticisms & Real-World Uses

What Is Adjusted Indexed P/E Ratio?

The Adjusted Indexed P/E Ratio, more commonly known as the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio or Shiller P/E, is a valuation metric used in investment analysis to assess whether a stock market or a broad index is overvalued or undervalued. This ratio belongs to the broader category of valuation metrics within financial analysis, and it aims to provide a more stable and long-term view of asset prices relative to corporate earnings. Unlike the traditional Price-to-Earnings (P/E) ratio, the Adjusted Indexed P/E Ratio smooths out cyclical fluctuations in earnings per share (EPS) by averaging them over an extended period, typically 10 years, and adjusting for inflation. This adjustment helps to minimize the distortion caused by short-term economic variations or business cycle peaks and troughs. The Adjusted Indexed P/E Ratio is particularly useful for long-term investing strategies, offering insights into potential future returns based on current market valuation levels.

History and Origin

The concept behind the Adjusted Indexed P/E Ratio was popularized by Nobel laureate economist Robert J. Shiller and his colleague John Y. Campbell. While the idea of smoothing earnings over several years for valuation purposes dates back to value investors Benjamin Graham and David Dodd in their 1934 text Security Analysis, Shiller and Campbell refined and extended this methodology. They developed the cyclically adjusted price-to-earnings ratio in the late 1980s, applying it specifically to the S&P 500 index. Their foundational work, particularly a 1998 article and Shiller’s book Irrational Exuberance, brought widespread attention to the ratio as a predictor of long-term market returns. Shiller’s research demonstrated how historically high CAPE values often preceded periods of lower subsequent real returns for equity markets, and vice-versa. Data for the S&P 500 CAPE Ratio, which began to be compiled from 1871, is publicly available on Robert Shiller's website.

##⁸ Key Takeaways

The Adjusted Indexed P/E Ratio (CAPE Ratio) averages inflation-adjusted earnings over 10 years to smooth out economic fluctuations.
It is primarily used as a long-term valuation tool for broad equity markets or indices, rather than individual stocks.
A higher Adjusted Indexed P/E Ratio generally implies lower expected long-term returns from equities, and vice versa.
The ratio aims to provide a clearer picture of market valuation by mitigating the impact of economic cycles.
While influential, the Adjusted Indexed P/E Ratio has limitations and should be considered alongside other financial ratios and economic factors.

Formula and Calculation

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

\text{CAPE Ratio} = \frac{\text{Current Real Price}}{\text{10-Year Average Real Earnings Per Share}}

Where:

Current Real Price: The current nominal price of the index or asset, divided by the Consumer Price Index (CPI) for the most recent month.
10-Year Average Real Earnings Per Share: The average of the past 10 years of reported annual earnings per share, with each year's earnings adjusted for inflation using the CPI for that period.

To calculate the 10-year average real earnings, each year's nominal earnings are first deflated by the CPI of that year to get real earnings. Then, these 10 years of real earnings are averaged. The current price is also deflated by the most recent CPI to align it with the real earnings. The Bureau of Labor Statistics (BLS) provides historical Consumer Price Index data which is crucial for this adjustment. The⁷ Federal Reserve Bank of St. Louis (FRED) also compiles the S&P 500 Cyclically Adjusted Price-Earnings Ratio data.

##⁶ Interpreting the Adjusted Indexed P/E Ratio

Interpreting the Adjusted Indexed P/E Ratio involves comparing its current value to its historical average and observing trends. A higher-than-average Adjusted Indexed P/E Ratio suggests that the market may be overvalued relative to its long-term earnings power, potentially indicating lower prospective returns for investors over the next 10 to 20 years. Conversely, a significantly lower-than-average Adjusted Indexed P/E Ratio could suggest an undervalued market, implying higher potential long-term returns. For example, the 20th-century average CAPE for the S&P 500 was around 15.21, corresponding to an average annual return of approximately 6.6% over the subsequent 20 years.

It is important to consider the context of interest rates and inflation when interpreting this ratio, as low real interest rates might justify higher equity valuations. This ratio is often used in portfolio management as one indicator among many to guide asset allocation decisions, helping investors to gauge overall market risk.

Hypothetical Example

Suppose an investor wants to use the Adjusted Indexed P/E Ratio to evaluate the broader stock market.

Gather Data: The investor finds the current S&P 500 index value is 5,500. They then collect the annual earnings per share for the S&P 500 for the past 10 years, along with the corresponding Consumer Price Index (CPI) for each year and the current CPI.
Adjust for Inflation: Each year's nominal EPS is divided by its respective CPI (scaled to a base year, e.g., 100), and then multiplied by the current CPI to bring all earnings into "real" current dollars. For instance, if Year 1 EPS was $100 and CPI was 200, and current CPI is 300, the real EPS for Year 1 in current dollars would be ($100 \times (300/200) = $150). This process is repeated for all 10 years.
Calculate 10-Year Average Real EPS: The investor sums these 10 inflation-adjusted EPS figures and divides by 10. Let's assume the average real EPS comes out to be $180.
Calculate Current Real Price: The current S&P 500 price of 5,500 is adjusted for inflation using the current CPI. If the current CPI is 300, and a base CPI (e.g., from Shiller's data) is 100, then the real price is (5,500 \times (100/300) = 1,833.33). (Note: Shiller's data often presents real price directly, using a historical CPI base.)
Compute Adjusted Indexed P/E Ratio:
$\text{Adjusted Indexed P/E Ratio} = \frac{1,833.33}{180} \approx 10.18$
In this hypothetical example, an Adjusted Indexed P/E Ratio of 10.18 would be significantly below the historical average, suggesting that the stock market is potentially undervalued and could offer robust returns over the long term. This provides a crucial perspective for making sound investment analysis decisions.

Practical Applications

The Adjusted Indexed P/E Ratio serves as a robust tool for assessing long-term market prospects across various applications in finance and economics. Investors, particularly those focused on long-term investing and value investing, often use this metric to gauge the overall expensiveness of equity markets. When the Adjusted Indexed P/E Ratio is significantly high, it might signal an overvalued market, leading investors to consider reducing equity exposure or diversifying into other asset classes like bonds or real assets. Conversely, a low Adjusted Indexed P/E Ratio can suggest an attractive entry point for accumulating equity.

For instance, after a period of prolonged economic growth, the ratio might climb, reflecting high valuations. Reports often highlight how rising inflation can influence global equity valuations, further underscoring the importance of inflation-adjusted metrics like the Adjusted Indexed P/E Ratio in current market environments. Fur⁵thermore, academic institutions and central banks frequently reference the CAPE Ratio in their research and policy discussions to understand macro-level financial stability and to project future market returns.

Limitations and Criticisms

Despite its utility as a long-term valuation tool, the Adjusted Indexed P/E Ratio faces several limitations and criticisms. One common critique is its backward-looking nature; by relying on 10 years of historical earnings, it may not adequately capture recent structural changes in the economy, technological shifts, or altered corporate accounting practices that impact current and future profitability. For³, ⁴ example, changes in tax policies or the increasing prevalence of share buybacks can distort how earnings per share are calculated, potentially making the ratio less accurate in modern markets.

An²other point of contention is its limited applicability to individual stocks. While effective for broad market indices like the S&P 500, the Adjusted Indexed P/E Ratio is not typically used for single-company market valuation, especially for companies with volatile or negative earnings. Cri¹tics also argue that the "normal" or average CAPE ratio might change over time due to persistent shifts in interest rates or long-term economic growth trends, making historical comparisons less reliable. Consequently, practitioners often advocate for considering the Adjusted Indexed P/E Ratio as one of many indicators in a comprehensive risk management framework, rather than relying on it in isolation.

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

The primary distinction between the Adjusted Indexed P/E Ratio (CAPE Ratio) and the standard Price-to-Earnings (P/E) ratio lies in their treatment of earnings and inflation. The traditional P/E ratio typically divides the current share price by the most recent 12 months of earnings per share (trailing P/E) or by estimated future earnings (forward P/E). This makes the standard P/E highly susceptible to short-term fluctuations in corporate profits and the business cycle. A company's earnings can be artificially inflated during economic booms or severely depressed during recessions, leading to distorted P/E readings.

In contrast, the Adjusted Indexed P/E Ratio addresses this volatility by using an average of 10 years of inflation-adjusted earnings. This smoothing effect provides a more stable and cyclically neutral view of a company's or market's earning power. While the standard P/E ratio offers a snapshot of current valuation, the Adjusted Indexed P/E Ratio aims to provide a long-term perspective, making it more suitable for identifying periods of broad market overvaluation or undervaluation influenced by underlying economic cycles. Investors use the standard P/E for quick comparisons of individual companies within an industry, whereas the Adjusted Indexed P/E Ratio is favored for macro-market valuation and long-term investing decisions.

FAQs

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

A high Adjusted Indexed P/E Ratio suggests that the overall stock market or index is relatively expensive compared to its long-term average earnings, adjusted for inflation. Historically, high readings have been associated with lower subsequent real returns over the next decade or two.

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

While a high Adjusted Indexed P/E Ratio has historically preceded significant market downturns (such as those before 1929, 2000, and 2008), it is not a precise market timing tool. It indicates long-term valuation levels and potential return expectations, not the exact timing of a crash. It should be used as part of a comprehensive investment analysis approach.

Is the Adjusted Indexed P/E Ratio used for individual stocks?

No, the Adjusted Indexed P/E Ratio is primarily designed for broad market indices like the S&P 500. Its methodology of averaging earnings over a decade to smooth out economic cycles makes it less relevant and potentially misleading for valuing individual companies, whose earnings patterns can be influenced by unique company-specific factors.

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

Inflation is directly accounted for in the Adjusted Indexed P/E Ratio. Both the price and the 10-year average earnings are adjusted for inflation using the Consumer Price Index (CPI), ensuring that the ratio reflects real (inflation-adjusted) values and provides a more accurate comparison over time.

What is a "normal" Adjusted Indexed P/E Ratio?

The "normal" or historical average Adjusted Indexed P/E Ratio for the U.S. stock market has been around 15 to 17. However, what is considered "normal" can shift over very long periods due to changes in economic growth trends, interest rates, and other macroeconomic factors, making it essential to evaluate the ratio within its historical context and alongside other financial ratios.