The CAPE ratio is used to analyze a publicly held company’s long-term financial performance while considering the impact of different economic cycles on the company’s earnings.
How does the CAPE Ratio work?
The CAPE Ratio, or the Cyclically Adjusted Price to Earnings ratio, also known as the Shiller P/E ratio, is a valuation measure typically applied to broad equity markets, especially for assessing whether a market is over or under-valued.
It is calculated by dividing the current market price of a stock or index by the average inflation-adjusted earnings over the previous 10 years.
The CAPE Ratio is a valuable tool for investors seeking to understand market valuation in a historical context. It helps in identifying potential bubbles or undervalued markets when used in conjunction with other indicators. However, relying solely on the CAPE Ratio for investment decisions can be misleading due to the influence of external economic factors and structural changes in financial markets.
If an index is currently trading at 2,600 and the average inflation-adjusted earnings over the past 10 years is $100, the CAPE Ratio would be 26 (2,600 / 100).
Calculation: To calculate the CAPE Ratio, you take the real (inflation-adjusted) earnings per share (EPS) for a stock or an index for the past 10 years, average them out, and then divide the current market price by this average EPS.
Interpretation: A higher CAPE Ratio suggests that a stock or market is potentially overvalued, implying that future returns might be lower. Conversely, a lower CAPE ratio may indicate undervaluation and potentially higher future returns.
How does the CAPE Ratio differ from the traditional P/E ratio?
The CAPE Ratio is different from the traditional P/E ratio in that it uses the average of 10 years of earnings, adjusted for inflation, instead of just one year’s earnings.
Is a high CAPE Ratio always a sign of an overvalued market?
Not necessarily. Some argue that structural changes in the economy or shifts in investment patterns can justify higher average CAPE Ratios over time.
Can the CAPE Ratio predict market crashes?
While a high CAPE Ratio has preceded some market downturns, it is not a precise predictive tool. It can indicate that the market is overvalued, which is a risk factor for a correction, but it does not predict timing or cause crashes.