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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 the 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 inflation.

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

 

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. The ratio also considers 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

An extremely high CAPE ratio means that a company’s stock price is substantially higher than the company’s earnings indicate and its stock is overvalued. Therefore, it is generally expected that the market will evenutally 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. 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. The first was in 1929 before the Wall Street crash that signaled the start of the Great Depression. The second was in the late 1990s before the Dotcom Crash, and the third came in 2007 before the 2007-2008 Financial Crisis.

 

Learn more about Financial Ratio with CFI’s Financial Analysis Fundamental Course

 

CAPE Ratio in Forecasting

There is believed to be a relationship between the CAPE ratio and future earnings. Shiller concluded that lower ratios tend to lead to higher returns for investors over time.

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 overly pessimistic view of future earnings.

 

Related Readings

We hope you’ve enjoyed CFI’s explanation of the CAPE ratio. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Financial Ratios
  • Guide to Financial Modeling
  • Projecting Balance Sheet Line Items
  • Financial Analysis Ratios Glossary

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