Adjusted long term p e ratio

What Is Adjusted Long-Term P/E Ratio?

The Adjusted Long-Term P/E Ratio, often known as the Cyclically Adjusted Price-to-Earnings (CAPE) ratio or Shiller P/E, is a valuation measure that uses inflation-adjusted earnings from the past decade to smooth out the effects of economic cycles. Unlike a traditional Price-to-Earnings (P/E) ratio, which typically uses trailing 12-month earnings per share, the Adjusted Long-Term P/E Ratio aims to provide a more stable and less volatile indicator of market valuation by averaging earnings over a longer period. This approach falls under the broader category of investment strategy and market analysis, helping investors assess whether a stock market index or the broader market is overvalued or undervalued. By incorporating a decade of earnings data, the Adjusted Long-Term P/E Ratio mitigates the impact of temporary fluctuations or a recession that might skew a shorter-term P/E ratio.

History and Origin

The Adjusted Long-Term P/E Ratio was developed by Nobel laureate Robert Shiller, a professor of economics at Yale University, along with John Campbell. Shiller popularized the measure in his book Irrational Exuberance, first published in 2000. The concept emerged from the recognition that traditional P/E ratios could be misleading due to the cyclical nature of corporate earnings. During periods of economic boom, earnings might be unsustainably high, leading to an artificially low P/E, while in downturns, depressed earnings could inflate the P/E ratio, suggesting overvaluation when prices are actually low. To address this market volatility, Shiller and Campbell proposed averaging earnings over 10 years and adjusting them for inflation. Shiller makes the historical data for the U.S. stock markets, including the CAPE ratio, publicly available through his Yale University website, with data extending back to 1871.¹⁴, ¹⁵, ¹⁶

Key Takeaways

• The Adjusted Long-Term P/E Ratio (CAPE) averages 10 years of inflation-adjusted earnings to smooth out economic cycles.
• It is used as a long-term valuation tool for assessing whether a market is overvalued or undervalued.
• A higher Adjusted Long-Term P/E Ratio generally suggests lower future real returns over the long term.
• The ratio helps investors make informed decisions about asset allocation by providing a broader historical context.
• Critics note that the ratio may not fully account for structural changes in the economy, corporate accounting practices, or persistently low interest rates.

Formula and Calculation

The formula for the Adjusted Long-Term P/E Ratio is:

Where:

• Current Price of Index: This refers to the current price level of the chosen stock market index, such as the S&P 500.
• Average of Last 10 Years' Inflation-Adjusted Earnings: To calculate this, the earnings per share for each of the past 10 years are first adjusted for inflation using a consumer price index (CPI). These 10-year real earnings are then averaged. The purpose of using real earnings is to ensure that comparisons across different time periods are not distorted by changes in purchasing power.

Interpreting the Adjusted Long-Term P/E Ratio

Interpreting the Adjusted Long-Term P/E Ratio involves comparing its current value to its historical average. A ratio significantly above its long-term average may suggest that the market is overvalued, implying lower prospective real returns over the next 10 to 20 years. Conversely, a ratio below its historical average could indicate an undervalued market, potentially forecasting higher long-term returns. For example, historically, when the CAPE ratio has been high, subsequent long-term stock market returns have often been lower, and vice versa. This concept is closely related to mean reversion, the idea that asset prices and economic indicators tend to revert to their long-term averages over time. Investors use this metric as a strategic guide for long-term investment strategy, rather than a short-term market timing tool.

Hypothetical Example

Consider an investor, Sarah, who is evaluating the overall U.S. stock market. She finds that the current S&P 500 index value is 5,000. She then gathers the real (inflation-adjusted) aggregate earnings per share for the S&P 500 over the past 10 years, which average out to $150.

Using the formula for the Adjusted Long-Term P/E Ratio:

Sarah then compares this value of 33.33 to the historical average Adjusted Long-Term P/E Ratio for the S&P 500, which has been around 17x. Since the current ratio is significantly higher than its historical average, she might interpret this as a signal that the market is currently overvalued, suggesting that future long-term returns might be lower than historical averages. This insight could influence her long-term asset allocation decisions.

Practical Applications

The Adjusted Long-Term P/E Ratio serves as a key tool for long-term investors, particularly in the realm of strategic asset allocation. It is frequently used by institutional investors, economists, and financial planners to gauge the overall attractiveness of equity markets for long-term horizons. For instance, when the ratio is elevated, some investors might consider reducing their equity exposure or diversifying into other asset classes, while a lower ratio might encourage increased equity exposure.

Economists and researchers also use the Adjusted Long-Term P/E Ratio to analyze historical market cycles and forecast potential future real returns. For example, discussions around the S&P 500's forward P/E ratio, often compared to long-term averages, are common in assessing market conditions and the potential for continued rallies¹³. Additionally, central banks like the Federal Reserve monitor broad equity market valuations as part of their financial stability framework, considering how high asset valuations, relative to interest rates and income flows, might reflect investor risk premium and appetite¹².

Limitations and Criticisms

While a valuable valuation metric, the Adjusted Long-Term P/E Ratio has its limitations and has faced criticism. One major critique is that it is inherently backward-looking, relying on historical earnings data rather than future prospects¹¹. Changes in accounting standards, particularly Generally Accepted Accounting Principles (GAAP) earnings, over the decades can make long-term comparisons challenging¹⁰. Some argue that shifts in corporate payout policies, where share buybacks have become more prevalent than dividends, can affect earnings per share growth rates and, consequently, the CAPE ratio's accuracy⁸, ⁹.

Another point of contention is the influence of persistently low interest rates on market valuations. Low interest rates can theoretically justify higher equity valuations because they reduce the discount rate applied to future earnings, making stocks more attractive relative to fixed-income investments⁶, ⁷. Critics also point out that the composition of major stock market indexes has changed significantly over time, with a greater weighting towards technology and information services companies that often command higher P/E ratios⁴, ⁵. Some argue that the ratio has spent a significant amount of time above its historical average in recent decades, leading to questions about its reliability as a strict mean reversion indicator for market timing², ³. Research Affiliates, for instance, has published analyses debating whether current high CAPE ratios are justified or signal lower future returns¹.

Adjusted Long-Term P/E Ratio vs. Trailing P/E Ratio

The primary difference between the Adjusted Long-Term P/E Ratio and the traditional Price-to-Earnings (P/E) ratio lies in their treatment of earnings. The standard P/E ratio typically uses a company's or index's trailing 12-month earnings per share in its calculation. This makes it a snapshot of current valuation relative to very recent earnings performance.

In contrast, the Adjusted Long-Term P/E Ratio, or CAPE, smooths out cyclical fluctuations by averaging the past 10 years of inflation-adjusted earnings. While the traditional P/E can be highly volatile, especially during or immediately after significant economic events like a recession where earnings might temporarily collapse or surge, the Adjusted Long-Term P/E Ratio provides a more stable, long-term perspective. Confusion often arises because both are P/E ratios, but their applications differ: the traditional P/E is useful for short-to-medium term company-specific analysis, whereas the Adjusted Long-Term P/E Ratio is generally applied to broad financial markets and used for long-term strategic investment strategy.

FAQs

What does a high Adjusted Long-Term P/E Ratio indicate?

A high Adjusted Long-Term P/E Ratio generally suggests that a stock market index or the broader market is overvalued compared to its historical averages, implying that investors should anticipate lower long-term real returns from equities in the future.

Can the Adjusted Long-Term P/E Ratio be used for market timing?

No, the Adjusted Long-Term P/E Ratio is primarily a long-term valuation tool and is not effective for short-term market timing. Its utility lies in providing context for long-term asset allocation decisions and understanding broad market conditions over decades.

Why does the Adjusted Long-Term P/E Ratio use 10 years of earnings?

The 10-year period is chosen to smooth out the cyclical nature of economic cycles and corporate profits. This helps prevent unusual one-off earnings results or short-term economic conditions from heavily skewing the valuation metric.

Is the Adjusted Long-Term P/E Ratio still relevant today?

Despite criticisms regarding its applicability in a changing economic landscape and accounting practices, many investors and researchers continue to view the Adjusted Long-Term P/E Ratio as a valuable metric for understanding long-term market valuation and potential future real returns. It provides a useful historical context that single-year earnings metrics cannot.