What is the CAPE Ratio?
posted on June 4th, 2014 by David
Dr Robert Shiller – Yale University Economist & founder of the CAPE ratio
The Cyclically Adjusted P/E Ratio (CAPE) also known as P/E 10 or the Shiller P/E, is a financial valuation measure that can be applied to an individual company or index. Expressed as a ratio it represents a company’s price relative to its average earnings (profits) over the last 10 years and as such provides an indication of whether a stock is priced relatively cheaply or expensive.
The CAPE ratio or Shiller P/E builds on the traditional P/E in two main ways. Firstly it factors out the impact of inflation which is essential when using multi-year data. Secondly it aims to smooth out the impact of economic and profit cycles which can cause large variance in year-to-year data. It does this by using the average of 10 years worth of earnings data rather than one year used for a traditional P/E ratio. Whilst this means the impact of outlying data points are essentially reduced it also means that the ratio is slow to react to fundamental changes in a company’s fortune. It is therefore suitable for providing a longer term perspective and is not designed as a short term predictor of market movements as critics are quick to point out.
CAPE ratio = Price of Stock / Average EPS
EPS = Earnings Per Share = Net Income – Preferred Dividends / Weighted Average Number of Common Shares Outstanding
Average EPS = (EPS * Inflation Multiplier) / 10