CAPE Ratio Explained

Investors investigate the P/E ratio as a common practice to decide the merit of an investment option. P/E ratio is a useful measurement of earning per share that tells investors about the profitability of an investment option. CAPE ratio is a valuation measure of calculating real P/E ratio over 10 years period to smooth out any fluctuation in company profit caused by the business cycle. CAPE is an acronym that stands for cyclically adjusted price-to-earnings ratio. It is also called Shiller P/E ratio after the name of American economist and Nobel laureate, Robert Shiller, the man behind popularizing CAPE.

But before we discuss Shiller P/E in detail, let’s discuss the P/E ratio a bit to clear our concept.

P/E ratio is a valuation metric which relates current stock price against the company’s earning-per-share (EPS). The P/E ratio is an important parameter used by investors and analysts to determine the relative value of a firm’s share; that is whether it is overvalued or undervalued. A high P/E ratio signifies that company shares are overvalued. Firms that are running in loss or have no income don’t have a P/E ratio, and hence, historical data plays a critical role in calculating P/E ratio.

The formula used in calculating Shiller P/E ratio is below

Financial analysts use the CAPE ratio to determine a firm’s long-term performance, isolating the impact of business cycle changes. Although CAPE Ratio is used widely, several experts argued it couldn’t predict future stock returns accurately.

What Does Shiller P/E Ratio Tell You?

CAPE ratio is a variation on P/E ratio, only cyclically adjusted. Similar to the P/E ratio, it also a measure to identify if a stock is overvalued or undervalued.

CAPE ratio is a measurement of company’s profit ratio, over a period, at different stages of an economic cycle. Since it takes economic fluctuations into consideration, including expansion and contraction, it gives a broader image of a company’s performance by smoothing out cyclical effects.  Benjamin Graham and David Dodd mentioned in their 1934 book that to get valuation ratio, while calculated for a period, gives better clarity.  How?

Company’s profit fluctuates over a period. When there is economic expansion, profitability rises because consumers spend more money. But during bad times, consumers exercise frugality, causing company profit to plunge.  The impact of profit swings due to economic cycles is more for companies in the cyclical sector like consumer durables, automobile, finance, compared to industries belonging to the defensive sector such as FMCG, utilities, or pharmaceuticals. CAPE ratio isolates economic factors impacting the firm’s profit and gives clarity over its long-term performance.

CAPE Ratio and Market Prediction

Company P/E ratio is widely used by investors and analyst to gauge the long-term performance of a company. But it also warns off investors when company stock is overvalued. Previously, the CAPE ratio gave warnings regarding market bubbles and crashes. When the P/E ratio is high, the market expects that the price will eventually correct itself to its actual value. Shiller suggested that lower Cape P/E signals higher return for investors over a period.

Criticism of CAPE ratio

CAPE ratio helps investors predict the future performance of a company. But it has limitations too. Some experts have pointed out that CAPE ratio is backwards-looking since it is calculated on historical data. Next, the formula uses GAAP (generally accepted accounting principles). However, accounting reporting rules have undergone significant changes since the formula was developed. So, a CAPE ratio calculated using GAAP principle may not give an accurate value, as Jeremy Seigel mentioned in his paper that CAPE ratio calculated using changed GAAP might provide an overly pessimistic value regarding future earnings.

Conclusion

CAPE P/E ratio throws light over a firm’s performance over a period to estimate future potential. Despite limitations, it is a critical valuation method used by analysts to measure the sustainability of a business, keeping economic fluctuation aside.