CAPE Ratio Definition

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The acronym of Cyclically-Adjusted Price-to-Earnings Ratio checks the profitability graph of a firm so that investors can easily decide whether to trust the entity with the investment. Calculating the ratio involves considering multiple economic changes that affect businesses from time to time.

Key Takeaways

  • CAPE ratio is the assessment metric that considers the average earnings of the businesses over 10 years.This ratio-based analysis helps investors make future predictions on market movement, considering the past records.The ratio is specifically applied to indices, letting investment players build strategies and decide whether to invest at that particular moment.It considers the economic changes that hugely impact cyclical businesses, giving investors an idea about whether the markets are overvalued or undervalued.

How Does CAPE Ratio Work?

The CAPE Ratio concept was developed by Professor Robert Shiller of Yale University to study the impact of economic ups and downs on the indices’ Price-to-Earnings (PE) ratio. The PE ratio, as the name implies, assesses the stock prices with respect to the earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more (EPS). The markets also refer to this ratio as Shiller PE Ratio.

Investors apply this ratio to the indices to check if the market is overvalued or undervalued. When they get a clear picture of the market, the investors can easily formulate effective investment strategiesInvestment StrategiesInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more and decide if it’s the right time to buy or sell the stocks. In addition, these ratios analyze the effect of economic changes on the market to make further decisions. 

When the economy witnesses expansion, the consumers spend more on purchasing products and items. Thus, the profits rise, thereby positively affecting the indices. On the other hand, during recessions, the market witnesses a negative cyclic impact. As the economic turmoil affects consumer’s employment and income level negatively, their purchasing power deteriorates, and they spend less on buying. This, in turn, reduces the profits of the companies, which affects the employment rate and earnings of the common people.

Formula

The formula that helps investors calculate CAPE Ratio is:

CAPE Ratio= Share Price / 10 Years Average Earnings Adjusted for Inflation

Examples

Let us consider the examples to understand the calculation of the ratio:

Example 1

The Excel sheet below shows the EPS data for the past ten years, adjusting the same by removing the inflation factor from each year’s EPS to arrive at the correct comparable per share earnings. The sheet also depicts the average of the 10-year inflation-adjusted EPS.

CAPE Ratio= 1000/52.13 =19.12

It shows how despite having the current PE ratio of 10, the CAPE or Shiller PE ratio is 19.12, indicating overvaluation of the index.

Example 2

Let us take another instance to understand this concept better. Below mentioned are the details to calculate the CAPE ratio for S&P 500.

  • PE Ratio = 16Cape Ratio = 32Historical Average PE Ratio = 17

The historical PE ratio based upon the simple averages is similar to the current PE ratio in the above case. Still, the index is very much overvalued, taking into account the Shiller PE ratio, which takes the inflation-adjusted PE ratio for the past 10 years. This gives a better picture of the PE ratio of the index and allow investors to make an informed decision.

The investors should not invest in the current high-priced market as reflected by the CAPE ratio, until there is a correction. As a result, the ratio declines slightly and comes to the normally expected PE ratio for the markets.

Interpretation

The Shiller CAPE ratio indicates a reliable relationship with future earnings. Therefore, the lower the ratios, the higher the investors’ expected returns. However, people often criticize the ratio for not taking into account the changes introduced in accounting reporting guidelines from time to time. 

Plus, the CAPE ratio chart is more mathematical, making it quite complicated for investors to use. Furthermore, as it ignores the latest changes in the accounting rules, like Generally Accepted Accounting Principles (GAAP), it becomes a less practical tool for investors. In addition, it ignores the demand-supply function, which is the basics of economics. Also, it hardly bothers about the preferences and investment patterns that change over time.

Advantages & Disadvantages

Shiller PE ratio usually predicts the future return from the stock or the index in the next 10 to 20 years by using the historical ten-year data and adjusting the same with the inflation factor to arrive at the correct earnings per share number.

One of the disadvantages of the CAPE ratio is that investors cannot compare businesses based on their performance 10 years ago and today. This is because it does not consider the increase in the demand for investment in stock markets as it was 10 years ago.

This article is a guide to what is Cape Ratio & its definition. Here we explain its role as Shiller PE Ratio, its formula, interpretation, and examples. You can learn more about valuation from the following articles: –

It is usually applied to the indices. It is a multiple private equity valuation calculated using earnings per share adjusted for cyclical economic changes and inflation. Developed by Robert Shiller, a professor from Yale University in the United States, it analyzes the economic situation’s impact on the indices’ PE ratio. It gives the investor an idea about whether the markets are overvalued or undervalued.

The ratio is calculated by dividing the share price by the average earning of a business for 10 years. This earning is inflation-adjusted. 

A Shiller PE ratio ranging between 10 and 15 is considered ideal. However, if the ratio is above 20, the market is overvalued. This warns investors to wait for the right time to invest. However, this ideal range might differ based on the industry or niche the investor is considering. 

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