Define CAPE Ratio

CAPE Ratio Definition

What Is the CAPE Ratio and What Does It Mean?

The CAPE ratio is a price-to-earnings ratio that analyses actual earnings per share (EPS) over a 10-year period to smooth out changes in company profits that occur over the business cycle. Yale University professor Robert Shiller popularised the CAPE ratio, which stands for cyclically adjusted price-to-earnings ratio. The Shiller P/E ratio is another name for it. The P/E ratio is a stock valuation indicator that compares the price of a firm to its earnings per share. The earnings of a corporation is divided by the number of outstanding equity shares to calculate EPS.

The ratio is commonly used to determine whether broad equity indexes are cheap or overpriced. While the CAPE ratio is a popular and commonly used metric, it has been questioned by some major industry experts as a forecast of future stock market performance.

The CAPE Ratio is calculated as follows: CAPE text ratio = fractextShare price10 - text year average, text inflation - text adjusted earnings

CAPE ratio = inflation-adjusted profits over a ten-year period

Price of a share

​What Is the CAPE Ratio and What Does It Mean?

Various economic cycle effects have a substantial impact on a company's profitability. During expansions, earnings skyrocket as customers spend more money, but during recessions, customers spend less, profits plummet, and profits can even become negative. While profit fluctuations in cyclical industries like commodities and financials are significantly higher than in defensive industries like utilities and pharmaceuticals, few companies can sustain consistent profitability in the face of a prolonged recession.

Because per-share profits fluctuate so much, Benjamin Graham and David Dodd advocated in their famous 1934 book, Security Analysis, that when considering valuation ratios, one should take an average of earnings over a period of at least seven or 10 years.

TAKEAWAYS IMPORTANT

• The CAPE ratio is used to assess a publicly traded company's long-term financial success while taking into account the effects of several economic cycles on its earnings.

• The CAPE ratio is used to identify whether a stock is overvalued or undervalued, comparable to the price-to-earnings ratio.

• By comparing a stock price to average profits, adjusted for inflation, over a 10-year period, the ratio evaluates the impact of economic variables.

Use of the CAPE Ratio as an Example

The cyclically adjusted price-to-earnings (CAPE) ratio first gained prominence in December 1996, when Robert Shiller and John Campbell presented data to the Federal Reserve suggesting that stock prices were rising significantly faster than earnings. Shiller and Campbell released their seminal paper "Valuation Ratios and the Long-Run Stock Market Outlook" in the winter of 1998, in which they smoothed earnings for the S&P 500 by taking an average of actual earnings over the previous ten years, dating back to 1872.

In January 1997, the ratio reached a new high of 28, with the only previous comparable high ratio (at the time) being in 1929. According to Shiller and Campbell, the ratio predicted that the market's true value would be 40% lower in ten years than it was at the time. The market meltdown of 2008 contributed to the S&P 500 dropping 60% from October 2007 to March 2009, proving that prediction to be extremely accurate.

The CAPE Ratio's Limitations

The CAPE ratio's detractors argue that it is useless since it is fundamentally backward-looking rather than forward-looking. Another difficulty is that the ratio is based on GAAP (generally accepted accounting standards) earnings, which have changed significantly over the years.

Because of changes in the way GAAP earnings are computed, Jeremy Siegel of the Wharton School issued a study in June 2016 claiming that estimates of future stock returns using the CAPE ratio may be unduly gloomy. Using consistent earnings data, such as operational earnings or NIPA (national income and product account) after-tax company profits, rather than GAAP earnings, enhances the CAPE model's forecasting capacity and projects better U.S. equities returns, according to Siegel.