Adjusted market p e ratio

What Is Adjusted Market P/E Ratio?

The Adjusted Market P/E Ratio is a valuation metric that accounts for cyclical variations in corporate earnings, providing a smoother, more reliable measure of a stock market's overall valuation level. Unlike the traditional price-to-earnings (P/E) ratio, which uses trailing 12-month earnings, the Adjusted Market P/E Ratio typically averages earnings over a longer period, often 10 years, and adjusts them for inflation. This adjustment helps to mitigate the impact of short-term economic fluctuations and unusual events that can distort single-year earnings, offering a clearer picture of long-term profitability and underlying valuation within the broader category of Valuation Metrics. The most well-known form of this ratio is the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, also known as the Shiller P/E, popularized by Nobel laureate Robert Shiller.

History and Origin

The concept of smoothing earnings to arrive at a more robust valuation metric dates back to the early 20th century. Value investors Benjamin Graham and David Dodd, in their influential 1934 text "Security Analysis," advocated for averaging a firm's earnings over five to ten years to counter the volatility of single-year earnings when assessing fundamental value.

However, the specific methodology for the Adjusted Market P/E Ratio, notably the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, was developed and popularized by Yale University Professor Robert J. Shiller and his colleague John Campbell. They presented their research to the Federal Reserve in December 1996, suggesting that stock prices were rising significantly faster than corporate earnings. In 1998, they published their seminal article, "Valuation Ratios and the Long-Run Stock Market Outlook," which introduced the concept of smoothing S&P 500 earnings by taking an average of real (inflation-adjusted) earnings over the preceding 10 years, extending back to 1872²². Shiller's work demonstrated that higher CAPE values historically predicted lower future returns for equities over subsequent 10-to-20-year periods²⁰, ²¹.

Key Takeaways

• The Adjusted Market P/E Ratio, commonly known as the CAPE ratio or Shiller P/E, smooths out cyclical fluctuations in earnings.
• It divides the current market price of an index by the average of its inflation-adjusted earnings per share over the past 10 years.
• A higher Adjusted Market P/E Ratio typically suggests lower long-term future returns for the stock market, and vice versa.
• It is primarily used as a long-term valuation indicator rather than a short-term market timing tool.
• The ratio helps investors make informed investment decisions by offering a normalized view of market valuation.

Formula and Calculation

The Adjusted Market P/E Ratio, specifically the CAPE ratio, is calculated by dividing the current real (inflation-adjusted) price of a stock market index by the average of its real earnings per share (EPS) over the past 10 years.

The formula is expressed as:

Where:

• Current Real Price of Index: The current nominal price of the stock market index, adjusted for inflation using a price index (e.g., Consumer Price Index).
• 10-Year Average Real EPS of Index: The average of the earnings per share for the index over the most recent 10 years, with each year's earnings figure also adjusted for inflation.

This method effectively smooths out the impact of business cycle peaks and troughs on corporate profitability, providing a more stable and representative earnings figure for valuation purposes.

Interpreting the Adjusted Market P/E Ratio

Interpreting the Adjusted Market P/E Ratio involves comparing its current value to its historical average. A high Adjusted Market P/E Ratio suggests that the stock market is expensive relative to its long-term average earnings, implying potentially lower future returns over the next decade or more¹⁹. Conversely, a low Adjusted Market P/E Ratio may indicate that the market is undervalued, suggesting higher long-term future returns.

For example, the long-term historical average CAPE for the S&P 500 has been around 16 to 17. When the ratio significantly deviates from this average, it prompts analysis regarding whether the deviation is justified by underlying economic conditions or reflects market exuberance or pessimism. The Federal Reserve Bank of San Francisco noted that extreme run-ups in the cyclically adjusted price-earnings ratio can signal an overvalued stock market. They also showed that macroeconomic variables can account for much of the CAPE ratio's movement, offering some justification for elevated levels, but also predicting modest declines in the ratio over the next decade, which would imply lower stock returns¹⁸.

It is important to understand that while the Adjusted Market P/E Ratio provides a valuable long-term perspective on valuation, it is not a precise market timing tool for short-term investment decisions¹⁷.

Hypothetical Example

Consider a hypothetical stock market index, "DiversiFund 500," with the following real (inflation-adjusted) annual earnings per share (EPS) over the last 10 years:

• Year 10: $105
• Year 9: $98
• Year 8: $92
• Year 7: $85
• Year 6: $78
• Year 5: $70
• Year 4: $65
• Year 3: $60
• Year 2: $55
• Year 1: $50

First, calculate the 10-year average real EPS:

Now, assume the current real market price of the DiversiFund 500 index is $2,000.

Using the formula for the Adjusted Market P/E Ratio:

If the historical average Adjusted Market P/E Ratio for the DiversiFund 500 index is 18.0, then a current ratio of 26.39 suggests that the index is currently trading at a higher valuation than its historical norm, indicating that future returns might be lower than average. This provides context for investors considering their asset allocation to this market.

Practical Applications

The Adjusted Market P/E Ratio serves several important purposes in financial analysis and investment strategy.

• Long-Term Market Valuation: It is widely used by institutional investors, economists, and academics to assess the overall valuation of major stock markets, particularly the S&P 500, over extended periods. This long-term perspective helps in understanding whether a market is in a secular bull or bear phase.
• Forecasting Long-Term Returns: Research by Shiller and others indicates that the Adjusted Market P/E Ratio has a strong inverse correlation with subsequent long-term future returns for the broader stock market¹⁵, ¹⁶. A high ratio suggests lower expected real returns over the next 10-20 years, while a low ratio suggests higher expected returns.
• Strategic Asset Allocation: Portfolio managers and financial planners use this ratio as one input when making strategic asset allocation decisions. For instance, if the Adjusted Market P/E Ratio is significantly high, they might consider reducing exposure to equities or favoring less expensive international markets.
• Economic Analysis: Macroeconomists utilize the Adjusted Market P/E Ratio to gauge the relationship between stock market valuations and macroeconomic conditions, including inflation, economic growth, and interest rates¹⁴. For example, a 2025 analysis noted that sectors with high P/E ratios, such as technology and consumer discretionary, could particularly benefit from declining interest rates as they amplify growth stocks valuations¹³.

Limitations and Criticisms

While the Adjusted Market P/E Ratio offers valuable long-term insights, it also faces several limitations and criticisms:

• Backward-Looking Nature: By design, the Adjusted Market P/E Ratio is backward-looking, relying on 10 years of historical earnings. Critics argue that past earnings do not always correlate with future earnings, especially in rapidly evolving industries or during periods of significant economic change¹¹, ¹².
• Accounting Standard Changes: Changes in accounting standards over time can affect reported earnings per share, potentially distorting historical comparisons of the Adjusted Market P/E Ratio. For instance, shifts from traditional dividend payouts to share repurchases can affect how earnings per share are calculated and thus influence the ratio's level¹⁰.
• Exclusion of Interest Rates: A notable criticism is that the standard Adjusted Market P/E Ratio does not explicitly account for prevailing interest rates⁹. In a low-interest-rate environment, investors might justify higher equity valuations (and thus higher P/E ratios) because the discount rate for future returns is lower, making future earnings streams more valuable in present terms⁷, ⁸.
• Not a Market Timing Tool: The Adjusted Market P/E Ratio is primarily a long-term valuation indicator and is not effective for predicting short-term market movements or tops and bottoms⁶. Markets can remain overvalued or undervalued for extended periods.
• Industry Differences: The ratio may not be directly comparable across different industries, as various sectors naturally exhibit different earnings growth patterns and capital structures⁴, ⁵. Additionally, it does not fully consider a company's financial health by ignoring its debt levels³.

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

The Adjusted Market P/E Ratio and the traditional Price-to-Earnings (P/E) Ratio are both valuation metrics, but they differ significantly in their calculation and intended use.

The traditional P/E Ratio divides a company's current market price per share by its earnings per share (EPS) over the most recent 12 months (trailing P/E) or projected future 12 months (forward P/E)². This ratio is highly sensitive to short-term fluctuations in earnings, which can be volatile due to business cycle changes, extraordinary events, or accounting adjustments. A company might have temporarily depressed earnings during a recession, leading to an artificially high P/E, or vice versa¹. It is often used for comparing companies within the same industry or for short-to-medium term analysis.

In contrast, the Adjusted Market P/E Ratio, particularly the CAPE ratio, aims to smooth out these short-term earnings volatilities by using an average of 10 years of inflation-adjusted earnings per share. This longer-term average provides a more stable earnings base, making the ratio less susceptible to temporary spikes or drops in profitability. The primary purpose of the Adjusted Market P/E Ratio is to assess long-term market valuation and predict broad future returns over decades, rather than short-term price movements. While the traditional P/E ratio can be misleading when single-year earnings are distorted, the Adjusted Market P/E Ratio offers a more normalized view of profitability, which is especially useful for value investing strategies that emphasize sustainable earning power.

FAQs

What is the primary purpose of the Adjusted Market P/E Ratio?

The primary purpose of the Adjusted Market P/E Ratio is to assess the long-term valuation of a broad stock market index, accounting for the cyclical nature of corporate earnings. By smoothing earnings over a decade and adjusting for inflation, it offers a more stable indicator of whether the market is overvalued or undervalued from a historical perspective.

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

Inflation is directly incorporated into the calculation of the Adjusted Market P/E Ratio. Both the price of the index and the historical earnings per share are adjusted for inflation. This ensures that the ratio reflects real, rather than nominal, economic performance, providing a more accurate comparison of valuation over long time horizons.

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

While a very high Adjusted Market P/E Ratio has historically preceded significant market downturns, it is not a precise indicator of impending market crashes or short-term corrections. Markets can remain at elevated or depressed Adjusted Market P/E Ratio levels for extended periods. It is best used as a long-term signal for expected future returns, not a timing tool for investment decisions.

Why use 10 years of earnings instead of just one year?

Using 10 years of average earnings helps to smooth out the significant fluctuations that can occur in corporate profits