Meaning of CAPE Ratio
CAPE Ratio stands for Cyclically Adjusted Price Earnings Ratio. It is the price-earnings ratio calculated for ten years instead of being calculated for a particular date or year. The ratio was first coined by the prominent American economist Robert Shiller. Therefore, it is also known as “Shiller P/E.” Another name for the ratio is the “P/E 10” ratio.
The formula for calculation of this ratio is:
Share price/ Average earnings for the last ten years, adjusted for inflation
Usage of CAPE Ratio
This financial ratio is used to assess whether a stock is overvalued or undervalued over a while. The share price is divided by the company’s earnings per share to calculate the Price Earnings ratio. EPS or Earnings per share is calculated by dividing the Annual Net Income by the total number of outstanding shares. The only difference between the P/E ratio and CAPE ratio is that the P/E ratio is for a particular point in time. In contrast, the calculation for the CAPE Ratio happens for ten years.
Investors use this ratio to ascertain if the pricing of the stock is correct or not. It also shows that investors are willing to take risks and invest to receive one unit of its earnings. Cyclical adjustment of the earnings shows the effect of business cycles and ups and downs. Also, it considers the impact of inflation, deflation, and even stricter situations like depression on the earnings of businesses over the last ten years. Thus, it helps to give a broader picture of a company’s sustainability of profits and earnings over so many years.
Importance and Interpretation
CAPE ratio provides a broader picture than the P/E ratio since one year is too short to judge the real earning potential of any business. Also, business conditions can be volatile in a particular year12. It will present an incomplete picture to the investors, resulting in ill-informed investments.
- The investors have a higher chance of earning good returns over the next 20 years with a low CAPE ratio. On the other hand, a very high CAPE ratio will mean that the company’s stock price is not in tune with its earnings. Therefore, over a period in all probability, it will trace back and tune with its earnings, and the stock price will eventually go down.
- CAPE ratio helps identify unusual bubbles, forecasting their bursts and market crashes. The S&P 500 index has a historical average CAPE ratio between 15-16. It has reached its highest levels exceeding 30 in very few instances. Three of the cases followed by the worst market crashes- the Great Depression of 1929, the Dotcom crash of the late 1990s, and last, was the 2007-08 Financial crisis.
- There is a direct relationship between the CAPE ratio and returns. The markets have shown historically averaged a gain of over 10% per whenever the CAPE Ratio was around or less than10. With the CAPE being 10-15, the returns average around 8% per year. The yields average 5% per year, with the CAPE being between 15 and 20. As the CAPE increases to higher levels between 20 and 25, the average returns fall to 3% per annum. With the CAPE higher than 25, the average returns slip to around 1% per annum.
Limitations of CAPE Ratio
Some of the limitations of the CAPE ratio are:
- The calculation of this ratio is done on historical data of the years already passed. It does not take into account future market conditions and any expansionary plans of the business.
- Businesses change very rapidly in modern times. A company cannot be judged by what it was ten years ago or even five years ago. Sectors such as retail and telecom are apt examples where the CAPE ratio is unreliable. Their earnings and profitability have changed considerably over the last few years, and thus, the CAPE ratio will not provide an appropriate picture.
- Accounting standards and treatment of various entries have changed significantly over the years. GAAP (Generally Accepted Accounting Principles) has seen many revisions and changes in itself. Hence, it becomes difficult to ascertain the correct average EPS for the last ten years.
- An increase in demand directly affects a stock’s price. In recent years, the need for stocks has increased significantly through direct investments, mutual funds, hedge funds, etc. Thus, stock prices can also rise without a change in a company’s earnings, and this ratio can give an incorrect picture.
CAPE Ratio is another way of looking at the market direction. But this is based on the past averaged earnings. Hence, it can’t be relied on entirely, as the stock market is the most dynamic. There would have been significant changes in the past, and thus the results may not be accurate. Its interpretation happens along with other indicators.