The CAPE Ratio (also known as the Shiller P/E or PE 10 Ratio) is an acronym for the Cyclically-Adjusted Price-to-Earnings Ratio. The ratio is calculated by dividing a company’s stock price by the average of the company’s earnings for 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.
The CAPE ratio is a variation of the Price-to-Earnings (P/E) ratio. Similar to the P/E ratio, the CAPE ratio aims to indicate whether a stock is undervalued or overvalued.
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 and Market Crashes
An extremely high CAPE ratio means that a company’s stock price is substantially higher than the company’s earnings would indicate and, therefore, overvalued. It is generally expected that the market will eventually correct the company’s stock price by pushing it down to its true value.
In the past, the CAPE ratio has proved its importance in identifying potential bubbles and market crashes. The historical average of the ratio for the S&P 500 Index is between 15-16, while the highest levels of the ratio have 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.
There is believed to be a relationship between the CAPE ratio and future earnings. Shiller concluded that lower ratios indicate 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 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.
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