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CAPE Ratio

The Cyclically-Adjusted Price-to-Earnings Ratio (or Shiller P/E, PE 10 Ratio)

What is the CAPE Ratio?

The CAPE Ratio (also known as Shiller P/E, PE 10 Ratio) is an acronym for the Cyclically-Adjusted Price-to-Earnings Ratio. The ratio is calculated by dividing the price by the average of the company’s earnings in the last ten years adjusted for the inflation.

Financial Analysts use the Cyclically-Adjusted Price to Earnings Ratio to assess long-term financial performance while isolating the impact of the economic cycle.

 

CAPE Ratio

 

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The CAPE ratio is a variation of the Price-to-Earnings (P/E) ratio. Similar to the P/E ratio, the CAPE ratio determines whether a stock price is undervalued or overvalued.

However, the CAPE ratio allows the assessment of a company’s profitability over different periods of an economic cycle. Also, the ratio also considers the economic fluctuations, including the economy’s expansion and recession. Essentially, it provides a broader view of a company’s profitability by smoothing out the cyclical effects of the economy.

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

 

CAPE Ratio

 

CAPE Ratio and Market Crashes

Since the CAPE ratio evaluates whether a stock price is overvalued or undervalued, the ratio can predict the future market corrections.

For example, an extremely high ratio means that a company’s stock price is substantially larger than the company’s earnings and its stock is overvalued. Therefore, it is generally expected that in the future, the market will correct the company’s stock price by pushing it down to its true value.

In the past, the CAPE ratio proved its significance in identifying potential bubbles and market crashes in the real world. It was calculated that the historical average of the ratio for the S&P 500 Index was between 15-16, while the maximum levels of the ratio exceeded 30. The record high levels occurred three times in the history of the U.S. financial markets: in 1929 before the Great Wall Street crash that signaled the start of the Great Depression, in the late 1990s before the Dotcom Crash, and in 2007 before the 2007-2008 Global Financial Crisis.

 

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CAPE Ratio in Forecasting

There is also a relationship between the CAPE ratio and future earnings. Shiller determined the historical CAPE ratios for the S&P 500 Index and investigated the earnings reports for the index. He concluded that lower ratios tend to lead to higher returns for investors in the subsequent 20 years.

However, there are criticisms regarding the use of the CAPE ratio in forecasting earnings. The main concern is that the ratio does not take into account the changes in accounting reporting rules. For example, recent changes in the calculation of earnings under the GAAP distort the ratio and provide an over-pessimistic view of future earnings.

 

Related Readings

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