Cape ratio

What Is CAPE Ratio?

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio is a widely recognized valuation metric used to assess whether a stock market or a broad equity market index is undervalued, overvalued, or fairly priced. This measure falls under the broader category of investment analysis. Unlike the standard price-to-earnings ratio, the CAPE Ratio smooths out short-term fluctuations in corporate earnings by taking a 10-year average of inflation-adjusted earnings per share. This long-term perspective aims to provide a clearer picture of market value by accounting for different phases of the market cycles and economic conditions, such as periods of rapid economic recession or expansion.

History and Origin

The concept behind the CAPE ratio can be traced back to value investing pioneers Benjamin Graham and David Dodd, who advocated for smoothing earnings over multiple years to gain a more accurate understanding of a company's true earning power. They noted that single-year earnings could be too volatile for reliable analysis. The CAPE Ratio, often referred to as the Shiller P/E or P/E 10 ratio, was later popularized by American economist and Nobel laureate Robert J. Shiller and his colleague John Campbell. Their research in the late 1980s and Shiller's subsequent work, notably his book Irrational Exuberance, brought significant attention to the ratio as a tool for evaluating market valuations over longer time horizons. Shiller's work often references a comprehensive dataset of U.S. stock market prices, dividends, and earnings going back to 1871.¹³

Key Takeaways

• The CAPE Ratio is a long-term stock market valuation measure that smooths out cyclical fluctuations in earnings.
• It is calculated by dividing the current stock price by the average of 10 years of inflation-adjusted earnings.
• A higher CAPE Ratio historically suggests lower future long-term real returns from equities.
• The CAPE Ratio is primarily applied to broad market indices, such as the S&P 500 Index.
• While useful for long-term forecasting, it is not considered a precise tool for short-term market timing.

Formula and Calculation

The CAPE Ratio is calculated using the following formula:

Where:

• Current Market Price: The current price of the stock index (e.g., the S&P 500).
• Average of Last 10 Years' Inflation-Adjusted Earnings Per Share: The arithmetic mean of the nominal earnings per share over the past decade, adjusted for inflation using a consumer price index or similar deflator. This adjustment ensures that earnings from different time periods are comparable in real terms.

Interpreting the CAPE Ratio

Interpreting the CAPE Ratio involves comparing its current value to historical averages to gauge the market's current valuation. A CAPE Ratio significantly above its historical average often suggests that the market is overvalued, implying potentially lower future returns over the subsequent 10 to 20 years. Conversely, a CAPE Ratio below its historical average might indicate an undervalued market, suggesting higher prospective returns. Historically, the average CAPE value for the S&P 500 Index has been around 16 to 17.¹² However, values have varied widely, reaching peaks above 40 during periods like the dot-com bubble in 2000.¹¹ It is important to consider the CAPE Ratio in conjunction with other market valuation metrics for a comprehensive view.

Hypothetical Example

Consider a hypothetical market index, "DiversiStock 100," that has the following inflation-adjusted earnings per share (EPS) over the last 10 years:

To calculate the average 10-year inflation-adjusted EPS:
(\frac{(3.00+3.20+2.80+3.50+3.10+3.40+3.00+3.30+2.90+3.60)}{10} = \frac{31.50}{10} = $3.15)

Now, assume the current market price of the DiversiStock 100 index is $90.

The CAPE Ratio would be:
(\frac{$90}{$3.15} \approx 28.57)

If the historical average CAPE for the DiversiStock 100 is 18, a current CAPE of 28.57 suggests that the index is currently trading at a higher valuation relative to its historical earnings trend, which might imply lower future long-term returns compared to its historical average. This analysis can inform decisions related to portfolio management.

Practical Applications

The CAPE Ratio is a tool used by institutional investors, economists, and financial analysts for long-term strategic asset allocation and forecasting. It helps in assessing the attractiveness of broad equity markets over a multi-year horizon, rather than for short-term trading decisions. For example, a high CAPE Ratio in a given market might lead an investor to consider underweighting equities in that market in favor of other asset classes or international markets with lower CAPE values.¹⁰ Research Affiliates, an investment management firm, discusses how CAPE can be incorporated into expected return models for various asset classes.⁸, ⁹ It is important to note that the CAPE Ratio is one of several metrics considered in sophisticated financial planning and investment strategies.

Limitations and Criticisms

While the CAPE Ratio offers a robust long-term perspective, it faces several criticisms and limitations. One common critique is that it is inherently backward-looking, relying on historical earnings data that may not accurately reflect future economic conditions or changes in corporate structures. Another significant concern revolves around changes in accounting standards over time. Jeremy Siegel, for example, has argued that shifts in Generally Accepted Accounting Principles (GAAP) for earnings calculations, particularly since the 1990s, can make historical CAPE comparisons less reliable. These accounting changes may systematically lower reported earnings, leading to artificially inflated CAPE ratios and potentially unwarranted pessimism about future equity returns.⁷

Furthermore, the CAPE Ratio's static composition assumption has been questioned. The S&P 500 Index, for which the CAPE Ratio is most commonly applied, regularly changes its constituent companies, adding new, often higher-growth firms and removing others. This dynamic composition can create a mismatch between the current market price and the 10-year average earnings, which includes earnings from companies no longer in the index or with different weights.⁵, ⁶ The increased prevalence of share buybacks over dividends as a method for returning capital to shareholders also complicates direct historical comparisons, as buybacks can impact earnings per share differently than dividends.³, ⁴ Despite its utility, the CAPE Ratio is not a perfect market-timing tool and should be used as part of a broader analytical framework.²

CAPE Ratio vs. Price-to-Earnings Ratio

The CAPE Ratio and the traditional price-to-earnings ratio (P/E Ratio) are both valuation multiples that relate a company's or market's price to its earnings. The key difference lies in the earnings component. The standard P/E Ratio uses a company's most recent trailing 12-month earnings per share. This makes the P/E Ratio highly sensitive to short-term fluctuations in earnings, business cycles, and one-time events. A company might have temporarily depressed earnings during a recession, leading to a very high P/E ratio that doesn't reflect its long-term profitability.

In contrast, the CAPE Ratio utilizes the average of 10 years of inflation-adjusted earnings. This averaging process smooths out the cyclical nature of corporate profits, providing a more stable and comprehensive view of valuation that accounts for an entire business cycle. While the P/E Ratio is useful for assessing current profitability and relative value, the CAPE Ratio is designed for long-term forecasting and understanding broad market valuation trends, making it less susceptible to short-term earnings volatility.

FAQs

What does a high CAPE Ratio mean?
A high CAPE Ratio generally indicates that the market or index is overvalued relative to its historical average earnings, suggesting that future long-term returns for equities might be lower than historical averages.

Is the CAPE Ratio a good market timing tool?
No, the CAPE Ratio is not designed as a market timing tool. It provides insights into long-term market valuations and potential future returns over decades, rather than predicting short-term market movements.¹

Why does the CAPE Ratio use 10 years of earnings?
The 10-year period is chosen to smooth out the effects of typical market cycles, including periods of economic expansion and economic recession. This helps to normalize earnings and provide a more stable basis for valuation.

Can the CAPE Ratio be applied to individual stocks?
While theoretically possible, the CAPE Ratio is predominantly used for broad market indices like the S&P 500 Index. Applying it to individual stocks can be less reliable due to company-specific events, changes in business models, or shorter corporate lifespans compared to entire market indices.

How does inflation affect the CAPE Ratio?
The CAPE Ratio adjusts past earnings for inflation. This ensures that earnings from different years are expressed in constant purchasing power, making them comparable and providing a more accurate historical context for the current market price.