What Is the CAPE Ratio?
The CAPE ratio, or cyclically adjusted price-to-earnings ratio, is a financial metric used to evaluate the stock market’s overall value. This ratio, devised by Yale University professor Robert Shiller, averages earnings per share (EPS) over a 10-year period and adjusts for inflation, mitigating the effect of short-term earnings volatility. Often applied to broad market indices, the CAPE ratio helps assess whether the market is undervalued or overvalued over long-term cycles.
The Magic Formula for the CAPE Ratio
The CAPE Ratio can be calculated using the following formula:
1CAPE Ratio = Share Price / 10-Year Average of Inflation-Adjusted Earnings
This method provides a more stable perspective of a company’s earnings compared to the traditional price-to-earnings (P/E) ratio, fostering more informed investment decisions.
What Does the CAPE Ratio Reveal?
A company’s profitability is heavily influenced by economic cycles. During expansions, consumer spending lifts profits, while in recessions, reduced spending can drive profits down, sometimes into losses. This effect is especially pronounced in cyclical sectors such as commodities and financials, though even defensive sectors like utilities and pharmaceuticals face profitability challenges during economic downturns.
Benjamin Graham and David Dodd emphasized in their classic work Security Analysis (1934) the importance of using a multi-year average for earnings to derive valuation ratios like the CAPE ratio. Their recommendation underscores the significance of adjusting for the high volatility in company profits.
Key Takeaways
- The CAPE ratio takes into account economic cycles to analyze long-term financial performance and stock valuation.
- Similar to the price-to-earnings ratio, the CAPE ratio assesses if a stock is overvalued or undervalued by comparing current stock prices to average, inflation-adjusted earnings over a decade.
- This method factors in economic swings, offering a stable financial snapshot.
Example of the CAPE Ratio in Action
The CAPE ratio gained fame in December 1996 when Robert Shiller and John Campbell presented evidence to the Federal Reserve, indicating stock prices were surging ahead of earnings. The cyclically adjusted price-to-earnings ratio had hit 28 in January 1997— a level only seen in 1929 before then. Their analysis suggested a potential market downturn, which was validated when the 2008 market crash caused the S&P 500 to drop by 60% from October 2007 to March 2009.
In the following decade, as the U.S. economy recovered, the S&P 500’s CAPE ratio steadily climbed, hitting 33.78 in June 2018, far above its historical average of 16.80. The previous two instances of the CAPE ratio exceeding 30 were in 1929 and 2000, stirring debates about a potential major market correction.
The Constraints of the CAPE Ratio
Despite its acclaim, the CAPE ratio has its detractors. Critics argue the ratio is backward-looking and fails to account for future earnings. Additionally, it relies on generally accepted accounting principles (GAAP), which have evolved significantly.
In June 2016, Wharton School’s Jeremy Siegel critiqued the CAPE ratio, suggesting it may be too pessimistic for predicting future equity returns due to the outdated calculation of GAAP earnings. According to Siegel, using more consistent earnings measures like operating earnings or NIPA after-tax corporate profits improves the ratio’s forecasting accuracy, suggesting higher future U.S. equity returns.
Related Terms: P/E Ratio, Earnings Per Share, GAAP, Market Correction.
