The Shiller PE CAPE Ratio: Current Market Valuations

what is cape ratio

The CAPE ratio was derived by Robert Shiller, an American economist and Nobel Prize Laureate in economics.

  1. However, the king of extremely high P/E ratios during bull cycles is the NASDAQ 100, which has an average P/E of 29.1, which is over 50% bigger than the DOW Industrial index.
  2. The first step to defining a good P/E ratio for investing is to compare it with relevant P/E averages.
  3. The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio the the S&P 500's current price divided by the 10-year moving average of inflation-adjusted earnings.
  4. This site provides equity research and investment strategies to give you the insight and data you need for managing your money through all market conditions.
  5. Join the new premium research service for timely deep-dive analysis of high-conviction investment opportunities.
  6. As you’ll notice, the CAPE ratio and the Cap/GDP ratio correlate very closely, which further strengthens the case that the CAPE ratio is a reliable measure of market valuation.

The risk-free rate could impact the company's value, so investors must consider this metric to get a better image of the company's financial performance in the long term. Investors interested in getting knowledge of the long-term company financial performance could find that the cape ratio is a better metric to answer their questions. Therefore, the firm's stock price is usually ultimately adjusted (increased) by the market to reflect the company's actual value. It is often applied to leading stock market indices, such as the S&P 500 or individual stocks, as an indicator of potential overvaluation or undervaluation compared to the assumed intrinsic value. It’s about gradual, small moves, and taking into account numerous valuation metrics and multiple long-term research examples of why they’re relevant and what they can tell us about forward returns. Sure, the U.S. stock market still produced decent returns even with elevated CAPE ratios, but if you had invested in the cheapest countries based on CAPE you would have done far, far better.

CAPE Ratio and Market Crashes

But by no means does the high P/E ratio necessarily signal that the company in question is currently overvalued by the market. As a result, the market would adjust and increase the company's stock price to reflect its value. This ratio is a tool that helps to evaluate a company's earnings over 10 to 20 years, flattening fluctuations and minimizing the business cycle's consequences. It also suggests that comparison of CAPE values can assist in identifying the best markets for future equity returns beyond the US market. The short answer is that yes, the Shiller P/E ratio has been one of the most consistent indicators to warn about long-term undervalued or over-valued stocks and indices. Roughly speaking, in a market with a bullish horizon, higher P/E ratios are the norm, as investors’ expectation is for the earnings to grow in the short-medium term.

The difference between the Shiller P/E ratio and the traditional P/E ratio is the time period covered in the numerator, as we mentioned earlier. While there is significant criticism (and controversy) surrounding the methodology by which inflation is measured, the Consumer Price Index (CPI) remains the most common measure of inflation in the U.S. Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

This ratio helps evaluate whether the stock price has been overvalued or undervalued for an extended period. Keep in mind that the stock price is undervalued if the cape ratio is higher than the P/E ratio. In contrast, overvaluation is indicated by the P/E ratio being more significant than the cape ratio.

what is cape ratio

This metric was developed by Robert Shiller and popularized during the Dotcom Bubble when he argued (correctly) that equities were highly overvalued. For that reason, it’s also casually referred to as the “Shiller PE”, meaning the Shiller variant of the typical price-to-earnings (P/E) ratio of stock. The CAPE ratio most often serves as a market indicator, so the share price refers to the market price of a stock market index. However, taking the average of a company’s reported EPS figures in the past ten years neglects a critical factor that affects the financial performance of all corporations, which is inflation.

Create a free account to unlock this Template

Join the new premium research service for timely deep-dive analysis of high-conviction investment opportunities. My free investing newsletter provides updates on the Shiller PE every six weeks, along with a variety of other macroeconomic updates and investment ideas. That shows us that in extreme situations involving small markets with just a handful of companies with major structural changes, the CAPE can be misleading. While Professor Robert Shiller may be credited for formally presenting the metric to the Federal Reserve and using it in academia, the concept of using a “normalized”, average figure for the earnings metric was not a novel idea.

This value states that the company's stock price is higher than what would be shown by the company's earnings and is overvalued. As a result, the market would adjust and lower the company's stock price to reflect its actual value. It is a variant of the more popular price to earning ratio and is calculated by dividing the current price of a stock by its average inflation-adjusted earnings over the last 10 years. The ratio is used to gauge whether a stock, or group of stocks, is undervalued or overvalued by comparing its current market price to its inflation-adjusted historical earnings record. An extremely high CAPE ratio means that a company’s stock price is substantially higher than the company’s earnings would indicate and, therefore, overvalued.

Denmark had nearly double the earnings growth as the US had,  their number of index companies decreased from 20 t0 11, and the healthcare sector went from 10% of the index to 60% of the index. As can be seen, during periods where the CAPE ratio of the S&P 500 became rather high, returns over the next decade and more were invariably rather poor. The solution offered by the Shiller P/E ratio is to bypass these cyclical periods by calculating the historical ten-year average, with the proper adjustments made to account for the effects of inflation. Similar to the P/E ratio, the CAPE ratio aims to indicate whether a stock is undervalued or overvalued.

Average vs. Trends in Earnings Per Share (EPS)

In other words, predicting future earnings cannot be accurate unless average earnings for five to ten years are considered and the results are adjusted for inflation. However, the earnings volatility rate is low during a more extended period as it smoothes out the fluctuations and business cycle consequences on the company's earnings. CAPE is a measure that uses the price-to-earnings ratio to evaluate a company's long-term financial performance while minimizing the economic cycle's impact. It is also known as Shiller P/E, which is often used to assess the S&P 500 stock market in the US. The CAPE Ratio (also known as the Shiller P/E or PE 10 Ratio) is an acronym for the Cyclically-Adjusted Price-to-Earnings Ratio.

The cyclically adjusted price-to-earnings ratio, commonly known as CAPE,[1] Shiller P/E, or P/E 10 ratio,[2] is a valuation measure usually applied to the US S&P 500 equity market. Then when you look at normal price-to-earnings, price-to-book, and price-to-sales, you have even more metrics to help determine if a market is overvalued or undervalued. You can also compare the current dividend yield to a longer-term average dividend yield.

Value investors Benjamin Graham and David Dodd argued for smoothing a firm's earnings over the past five to ten years in their classic text Security Analysis. Graham and Dodd noted one-year earnings were too volatile to offer a good idea of a firm's true earning power. In a 1988 paper [5] economists John Y. Campbell and Robert Shiller concluded that “a long moving average of real earnings helps to forecast future real dividends” which in turn are correlated with returns on stocks. The idea is to take a long-term average of earnings (typically 5 or 10 year) and adjust for inflation to forecast future returns. The long term average smooths out short term volatility of earnings and medium-term business cycles in the general economy and they thought it was a better reflection of a firm's long term earning power.

How to calculate the Shiller P/E Ratio?

It is generally expected that the market will eventually correct the company’s stock price by pushing it down to its true value. The cyclically adjusted price-to-earnings (CAPE) ratio initially came into the spotlight in December 1996, after Robert Shiller and John Campbell presented research to the Federal Reserve that suggested stock prices were running up much faster than earnings. During a recession, stocks fall, but corporate earnings fall sharply as well, which can temporarily raise the P/E ratio. Since we want to buy when the P/E is low, this gives us a false signal that the market is expensive, that we shouldn’t buy, when indeed it’s the best time to buy. Unlike the traditional price to earnings ratio (P/E), the CAPE ratio attempts to eliminate fluctuations that can skew corporate earnings, i.e. “smoothen” the reported earnings of companies. Due to yield's impact on market value, investors should consider this metric; otherwise, they may get an inaccurate image of the company's performance in the short- or long-term.