Cape Ratio

CAPE Ratio is a market measurement tool that tracks fluctuations in a company's profits over 10 years to help investors make effective investment decisions. The ratio helps them predict future movements in the market for a specific period and identify the profits they can expect for that business cycle.

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.

• 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.

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 share (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 strategies 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.

The formula that helps investors calculate CAPE Ratio is:

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

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= Share Price / 10 Years Average Earnings Adjusted for Inflation

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 = 16
• Cape Ratio = 32
• Historical 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.

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.

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: -

• What is Calmar Ratio?
• Omega Ratio
• Herfindahl-Hirschman Index
• Transaction Multiples
• Internal Growth Rate Formula