Definition
The CAPE ratio, short for Cyclically Adjusted Price to Earnings ratio, is a valuation measure that uses real per-share earnings over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. It is designed to measure a company’s long-term earnings power because it less sensitive to short-term economic fluctuations. It was developed by economist Robert Shiller and is also known as the Shiller P/E ratio.
Key Takeaways
- The CAPE Ratio, or Cyclically Adjusted Price to Earnings Ratio, is a valuation measure that is generally applied to broad equity markets. It is defined as price divided by the average of ten years of earnings adjusted for inflation, hence providing a longer-term, inflation-adjusted measure.
- The CAPE Ratio is used to assess potential returns from equities over longer time frames. It is particularly useful in comparing current market valuations to historical ones, providing insights into potential over or under-valuations of the market.
- Despite its usefulness, the CAPE Ratio has its limitations. It may not be reliable for predicting short-term market movements and does not take into account changes in tax laws, regulations or structural changes in the economy. Additionally, it relies on the accuracy and consistency of reported earnings, which can be subject to manipulation and changes in accounting standards.
Importance
The CAPE (Cyclically Adjusted Price to Earnings) Ratio is important as it provides a robust measure of a company’s valuation, aiding investors in making informed investment decisions.
Unlike the standard P/E ratio, which uses only the earnings from one year, the CAPE ratio averages earnings over a decade, mitigating the effects of economic cycles.
Hence, it gives a more comprehensive and accurate picture of a company’s earning potential, considering both short-term and long-term prospects.
It helps in identifying overvalued and undervalued stocks, as well as predicting future market returns, promoting strategic investment planning.
Explanation
The CAPE (Cyclically Adjusted Price to Earnings) ratio, also known as the Shiller P/E ratio, is a popular and widely-used metric in financial analysis and investment decision-making. Its main purpose is to gauge the valuation of a company or market relative to its historical average, allowing investors to determine if a stock or market is overvalued or undervalued.
By incorporating earnings data for up to a decade, the CAPE ratio provides a smoothed and cyclically-adjusted perspective of a company or market’s P/E ratio that may be more reflective of its long-term earnings potential. The name “cyclically adjusted” derives from the ratio’s intent to account for business cycle fluctuations.
P/E ratios of companies can vary widely due to changes in earnings caused by the cyclic nature of business operations, making year-to-year comparisons difficult. By averaging earnings over a significant period (typically 10 years), the CAPE ratio irons out temporary variations and provides a clearer view of a company’s sustainable earning power.
As such, it is a vital tool for investors looking to minimize risk and optimize potential returns in the longer term.
Examples of Cape Ratio
The CAPE (Cyclically Adjusted Price Earnings) Ratio, also known as the Shiller P/E ratio, is used to assess the valuation of a company’s stock price related to its per-share earnings over a 10-year inflation-adjusted period. Here are three real-world examples:
**S&P 500 Index**: Analysts often use the CAPE ratio to assess the overall valuation of the stock market. For instance, as of February 2022, the CAPE ratio for the S&P 500 index, which includes many of America’s largest companies, was around 38 – considerably higher than the historical average around 16 to
This suggests that the market, as a whole, is quite overvalued and might encounter significant downward adjustments or slower growth in the future.
**Tech Stocks Valuation**: Tech giants like Amazon, Apple, and Google often have very high CAPE ratios. The CAPE ratio of Amazon was around 70 in 2021, showing that investors were willing to pay a significant premium for these companies’ potential for outstanding future earnings growth, despite their high valuations by historical standards.
**Emerging Market Stocks**: The CAPE ratio can also illustrate cheaper markets. For example, in 2020, the CAPE ratio for stocks in emerging markets such as Russia and Turkey was lower than 10, suggesting these markets were undervalued compared to historical averages. This could indicate a potential buying opportunity for long-term investors looking for value investments. However, low CAPE ratios can also suggest possible economic or political instability, which would reflect higher perceived risk by investors.Keep in mind that while useful, the CAPE ratio is just one indicator, and should be used in conjunction with other financial analysis tools. This makes it easier to paint a complete picture of an asset’s potential risk and reward.
FAQs for Cape Ratio
1. What is the Cape Ratio?
The Cape Ratio, also known as the CAPE (Cyclically Adjusted Price-to-Earnings) Ratio or Shiller PE, is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.
2. How is Cape Ratio calculated?
The Cape Ratio is calculated by taking the market value per share divided by earnings per share (EPS) over a 10-year period, adjusted for inflation. In other words, CAPE ratio = Market Value per Share / 10 Year Average Earnings per Share (Adjusted for Inflation).
3. Why is the Cape Ratio important?
The Cape Ratio is important because it adjusts for business-cycle effects and allows for a more meaningful comparison with historical norms. Additionally, it can provide a smoother estimate of long-term earnings power, helping investors to understand if current prices are high or low relative to sustainable earning power.
4. Is a high Cape Ratio good or bad?
A high Cape Ratio can be interpreted in two ways. It either suggests that the asset is overpriced relative to its 10 years’ earnings fundamentals, indicating a potential downturn in future returns, or it could signal that investor sentiment is bullish about the company’s future prospects. As such, the Cape Ratio isn’t inherently good or bad, it’s the context and comparative ratio analysis that provides value.
5. Can I use Cape Ratio to compare different companies?
While the Cape Ratio can be useful in comparing different companies, it’s essential to remember that different industries have different average CAPE ratios. CAPE ratios should ideally be used to compare companies within the same sector. Comparing the CAPE ratio of a tech company to that of a utility company may not give an accurate assessment.
6. Where can I find data to calculate the Cape Ratio?
The data required to calculate the Cape Ratio, specifically the company’s price per share and earnings per share, can typically be found in the company’s annual or quarterly reports. Additionally, many financial websites provide this information.
Related Entrepreneurship Terms
- Cyclically Adjusted Price Earnings (CAPE)
- Shiller P/E
- Market Valuation
- Price Earnings Ratio (P/E Ratio)
- Standard & Poor’s 500 Index (S&P 500)
Sources for More Information
- Investopedia: A comprehensive website for learning about investing, financial concepts including the CAPE Ratio.
- Bloomberg: A global hub for finance news and articles that may contain detailed explanations and current news about the CAPE Ratio.
- MarketWatch: A website providing financial information, business news, analysis, and stock market data that regularly discuss financial concepts like the CAPE Ratio.
- CNBC: An American pay television business news channel which provides financial market coverage and business information.
