Cyclically Adjusted Price to Earnings Ratio

What is the Cyclically Adjusted Price-Earnings Ratio?

The Cyclically Adjusted Price-Earnings Ratio (CAPE Ratio), also known as the Shiller P/E or PE10, is a valuation measure for stock markets introduced by economist Robert Shiller.

The CAPE Ratio improves upon the traditional price-earnings ratio by accounting for the impact of economic cycles on corporate earnings. The traditional P/E ratio is simply the ratio of the current stock price to the earnings (EPS) of a single year. However, since economic fluctuations can cause significant changes in corporate earnings at different stages, the traditional P/E ratio can become inaccurate during cyclical peaks or troughs.

To address the shortcomings of the traditional P/E ratio, the CAPE Ratio uses earnings data from the past 10 years, adjusted for inflation, to reflect actual purchasing power. The goal is to eliminate the volatility of single-year earnings and better represent a company's performance over an entire economic cycle.

Characteristics of the CAPE Ratio

Although different regions, industries, and economic cycles can affect the CAPE Ratio, it generally has the following characteristics.

1. Considers economic cycles comprehensively: By using inflation-adjusted earnings data from the past 10 years, it eliminates the volatility of single-year earnings, providing a more comprehensive reflection of a company's performance over the full economic cycle.
2. A relatively robust valuation metric: The CAPE Ratio avoids the limitations of single-year earnings data, reducing the impact of short-term fluctuations on valuations, and better reflecting a company's long-term profitability.
3. Market valuation indicator: It is commonly used to assess whether the stock market is overvalued or undervalued. A CAPE Ratio higher than the historical average may indicate an overvalued stock market, while a ratio lower than the historical average may suggest an undervalued market.
4. Long-term perspective: Employing a long-term view to evaluate market valuation helps investors better understand the market's valuation status and make informed investment decisions.
5. Influenced by economic factors: While the CAPE Ratio mitigates short-term volatility, it is still affected by broader economic factors.

Functions of the CAPE Ratio

As one of the most important stock market indices, the CAPE Ratio serves several functions in the financial markets, especially the stock market.

1. Market valuation assessment: The CAPE Ratio is often used to determine whether the stock market is overvalued or undervalued. A CAPE Ratio above the historical average suggests potential overvaluation, while a ratio below the historical average suggests potential undervaluation.
2. Provides a long-term perspective: By using a long-term view to assess market valuation, investors can better understand the valuation status of the market and make informed investment decisions.
3. Avoids short-term volatility impacts: Since the CAPE Ratio uses 10 years of earnings data, it reduces the influence of short-term fluctuations on valuations, helping investors to more comprehensively evaluate market valuation, rather than overly focusing on short-term changes.
4. Aids in investment decisions: Provides a valuable reference for investors to judge the valuation level of the stock market. Investors can use the CAPE Ratio along with other indicators and fundamental analysis to make more accurate investment decisions.
5. Measures risk and return: It can be used to gauge the risk and return of the stock market. A higher CAPE Ratio may indicate higher market risk, while a lower CAPE Ratio might suggest higher potential returns.

Factors Affecting the CAPE Ratio

The CAPE Ratio is a relatively complex valuation metric influenced by various factors.

1. Stock prices: The CAPE Ratio is calculated by dividing the current stock price by the average inflation-adjusted earnings over the past 10 years. Fluctuations in stock prices directly affect the CAPE Ratio value.
2. Earnings levels: The historical inflation-adjusted earnings data over the past 10 years are key components in calculating the CAPE Ratio. Changes in earnings levels will impact the CAPE Ratio value.
3. Inflation rate: Inflation is an adjustment factor in calculating the CAPE Ratio. Higher inflation can lead to greater adjustments in earnings, thereby affecting the CAPE Ratio calculation.
4. Economic cycles: The CAPE Ratio provides a more comprehensive view of a company's performance over the entire economic cycle. Changes in economic cycles, especially recessions or recoveries, can affect the CAPE Ratio value.
5. Interest rates: Interest rates can influence stock market valuations. Lower interest rates typically push stock prices higher, which can affect the CAPE Ratio value.
6. Market sentiment: Market and investor sentiment can cause significant fluctuations in stock prices, thereby impacting the CAPE Ratio value.
7. Macroeconomic factors: Broader economic factors, such as GDP growth rates and unemployment rates, can also affect the CAPE Ratio calculation.

Calculation and Case Study of the CAPE Ratio

Calculation Method

1. Collect the company's earnings data for the past 10 years (usually using earnings per share).
2. Adjust the earnings data for inflation over the past 10 years to eliminate the impact of inflation on earnings.
3. Divide the current stock price by the average inflation-adjusted earnings over the past 10 years to obtain the CAPE Ratio.

Case Study

Suppose a company's earnings per share over the past 10 years are: $10 in 2013, $12 in 2014, $14 in 2015, $16 in 2016, $18 in 2017, $20 in 2018, $22 in 2019, $24 in 2020, $26 in 2021, and $28 in 2022. Based on this, we calculate the company's 2022 CAPE Ratio.

1. Calculate the average earnings over the past 10 years: (10 + 12 + 14 + 16 + 18 + 20 + 22 + 24 + 26 + 28) / 10 = $19.0.
2. Adjust for inflation: Assuming the CPI in 2022 is 120, the inflation-adjusted earnings for 2022 = $28 / (CPI/100) = $28 / (120/100) = $23.33.
3. Calculate the CAPE Ratio for 2022: Assuming the current stock price is $300, the CAPE Ratio = Current stock price / 2022 adjusted earnings = $300 / $23.33 ≈ 12.86.

The above calculation shows that the company's CAPE Ratio for 2022 is approximately 12.86.