The P/E 10 Ratio, also known as the cyclically adjusted price earnings (CAPE) ratio, is a valuation measure typically applied to broad equity indices. It utilizes the average inflation-adjusted earnings from the previous 10 years to provide a normalized view of a stock’s price relative to its historical earnings.
Calculation of the P/E 10 Ratio
To calculate the P/E 10 Ratio, follow these steps:
- Collect Data: Obtain the earnings per share (EPS) data for the target company or index for the past 10 years.
- Adjust for Inflation: Adjust these earnings values for inflation to ensure consistency in current dollar terms.
- Average Earnings: Calculate the average of these inflation-adjusted earnings.
- Determine Price: Note the current price of the stock or index.
- Compute Ratio: Divide the current price by the average of the inflation-adjusted earnings.
Mathematically, it can be represented as:
Importance of the P/E 10 Ratio
The P/E 10 Ratio smooths out fluctuations in corporate profits that can often distort assessments of a company’s true valuation. By using a 10-year average, it provides a more stable and long-term view of earnings performance, making it particularly useful during volatile economic cycles.
Examples
Consider a hypothetical stock with the following inflation-adjusted EPS over 10 years:
| Year | EPS |
|---|---|
| Year 1 | $5.00 |
| Year 2 | $5.20 |
| Year 3 | $5.50 |
| Year 4 | $4.80 |
| Year 5 | $6.00 |
| Year 6 | $5.70 |
| Year 7 | $6.30 |
| Year 8 | $5.50 |
| Year 9 | $6.10 |
| Year 10 | $6.00 |
Average EPS over 10 years:
With a current stock price of $100, the P/E 10 ratio is:
Historical Context and Applicability
The concept of the P/E 10 Ratio was popularized by Yale economist Robert Shiller, and is sometimes referred to as the “Shiller P/E”. It’s widely used in equity analysis for its ability to provide insights into market valuation over long periods, shielding investors from short-term market disruptions.
Related Terms
- P/E Ratio (Price-to-Earnings Ratio): Measures the current price relative to the earnings of a company.
- Forward P/E Ratio: Based on forecasted earnings for the next 12 months.
- Trailing P/E Ratio: Uses earnings from the previous 12 months.
- Earnings Yield: The inverse of the P/E ratio, useful for comparing earnings to bond yields.
FAQs
Q1: What is the main advantage of using the P/E 10 Ratio? A1: The primary advantage is the smoothing of short-term fluctuations, thus providing a more stable and long-term view of a company’s valuation.
Q2: Can the P/E 10 Ratio be used for individual stocks? A2: While commonly used for broad indices, it can also be adapted for individual stock analysis if sufficient historical earnings data are available.
Q3: How does inflation adjustment affect the P/E 10 Ratio? A3: Adjusting for inflation ensures that earnings are measured in constant value terms, making year-on-year comparisons more realistic.
References
- Shiller, Robert. “Market Volatility” - MIT Press.
- Graham, Benjamin. “The Intelligent Investor” - Harper & Brothers.
Summary
The P/E 10 Ratio, or cyclically adjusted price earnings ratio, is a powerful tool for assessing the long-term valuation of equity indices and individual stocks. By averaging inflation-adjusted earnings over a decade, it mitigates the impact of short-term economic fluctuations, offering a clearer picture of true market value. Employing this ratio can significantly enhance investment strategies and risk assessments.
