The Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, also known as the Shiller PE Ratio, is a financial metric used to assess long-term stock market valuations by adjusting past company earnings for inflation. It was popularized by economist Robert Shiller and is widely utilized by investors to determine market affordability and to predict potential future returns.
Understanding the Formula
The CAPE Ratio is calculated as follows:
Where “real earnings” refers to inflation-adjusted earnings over the trailing ten years.
Components of the Formula
- Current Market Price: The current market price of a stock or a stock index.
- Real Earnings: Average earnings over the last ten years, adjusted for inflation. By smoothing out fluctuations, this provides a more stable and accurate reflection of a company’s earning power.
Uses of the CAPE Ratio
Long-Term Valuation
Investors use the CAPE Ratio to gauge if the stock market or a specific stock is overvalued or undervalued based on historical earnings performance. A high CAPE Ratio suggests that the market is overvalued, implying lower future returns, while a low CAPE Ratio indicates undervaluation with potential for higher future returns.
Predicting Future Returns
Empirical studies have shown that the CAPE Ratio has predictive power over long-term returns. Typically, higher CAPE Ratios are associated with lower future returns, and vice versa.
Comparing Markets
The CAPE Ratio can be used to compare different markets globally. By evaluating various stock indices using the CAPE Ratio, investors can identify which markets might offer better investment opportunities.
Examples of the CAPE Ratio in Action
Historical Context
During the dot-com bubble, the CAPE Ratio for the S&P 500 reached an all-time high of around 44. This indicated extreme overvaluation, and subsequent returns for that period were notably lower. Conversely, in the aftermath of the 2008 financial crisis, the CAPE Ratio dropped significantly, suggesting attractive valuation levels for long-term investors.
Industry Applications
Different industries have varied historical CAPE Ratios. Technology stocks might exhibit higher ratios due to growth expectations, while utilities may have lower CAPE Ratios reflecting stable and predictable earnings.
Special Considerations
Applicability to Different Markets
While the CAPE Ratio is a valuable tool, it may not be equally applicable to all markets, especially emerging markets where historical earnings data might be less reliable.
Inflation Adjustments
Accurately adjusting for inflation is crucial for maintaining the integrity of the CAPE Ratio. Incorrect adjustments can result in misleading interpretations of stock valuations.
FAQs
What is the difference between the CAPE Ratio and the PE Ratio?
How often should the CAPE Ratio be recalculated?
Is the CAPE Ratio a foolproof investment tool?
Related Terms
- PE Ratio: Price-to-Earnings Ratio, a valuation measure comparing current share price to per-share earnings.
- Earnings Yield: The inverse of the PE Ratio, representing earnings divided by price.
- Price-to-Book Ratio: A comparison of market value to book value.
Summary
The CAPE Ratio (Shiller PE Ratio) is a potent metric for evaluating stock market valuations by adjusting historical earnings for inflation, thus providing a clearer long-term outlook. Its usage ranges from comparing global markets to predicting future returns, although it’s most effective when used in conjunction with other analytical tools.
References
- Shiller, Robert J. “Irrational Exuberance.” Princeton University Press.
- Campbell, John Y., and Robert J. Shiller. “Valuation Ratios and the Long-Run Stock Market Outlook.”
By understanding the CAPE Ratio, investors can make more informed decisions based on historical valuation patterns and current market conditions.
