The cyclically adjusted price-to-earnings ratio is a variation on the classic price-to-earnings ratio that attempts to provide better long-term guidance on how a stock price compares to the underlying value of the company.
Keep reading to learn how to assess both individual stocks and entire foreign stock markets using the CAPE ratio.
Definition and Examples of the Cyclically Adjusted Price-to-Earnings Ratio
Invented by Nobel prize-winning economist Robert Shiller, the cyclically adjusted price-to-earnings ratio is a way of assessing how a stock's price compares to its value. Unlike the standard price-to-earnings ratio, the cyclically adjusted price-to-earnings ratio attempts to better account for long-term trends. This can make it a valuable tool for U.S. investors looking for opportunities abroad.
Investing in frontier and emerging markets is often much riskier than investing in domestic markets for U.S.-based investors, with factors like political risk and currency risk affecting equity valuations in a big way. To justify these added risks, investors must ensure a sufficiently high level of expected returns, driven by rapidly growing economies, favorable demographic trends, and other factors. That's why these investors need more tools like the CAPE ratio.
As with the standard P/E ratio, the higher the cyclically adjusted price-to-earnings ratio, the more overextended the stock price is believed to be. When the stock price runs too far ahead of the underlying value, investors could expect a pullback.
- Acronym: CAPE ratio
- Alternative name: Shiller P/E, P/E 10 ratio
How Do You Calculate the CAPE Ratio?
The CAPE ratio is calculated by dividing the current price of a single stock or a broad stock market index by the average inflation-adjusted earnings of the stock or the index components over the past 10 years. Instead of calculating each year's specific inflation level, some analysts apply a set inflation multiplier to each year’s EPS before dividing the total by 10 (to average out the decade's worth of EPS data).
How the CAPE Ratio Works
In general, the higher the CAPE ratio, the lower the expected annual returns in coming years. This assessment works for domestic stock indexes like the S&P 500, but the same metric can also be applied to frontier and emerging equity indexes to determine their valuation relative to historical norms. This helps to get a long-term view of a market that may be more subject to short-term volatility than an index like the S&P 500.
Some exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are designed to capitalize on changes in the CAPE ratio as a whole and between industry subsets. As the CAPE ratio of a given investment or sector decreases, an ETF or ETN following this strategy will add more of that investment or sector to the holdings.
What It Means for Individual Investors
The CAPE ratio can be helpful for any investor—especially a value investor—looking for a way to assess stock prices and find cheap investments. International investors may stand the most to gain from using the CAPE ratio since the long-term view helps investors find good opportunities in volatile markets abroad.
International investors can quickly find CAPE ratios for various countries around the world using free tools like Star Capital’s Global Stock Market Valuation Ratios. There are also tools, such as CAPERatio.com, which can help calculate the metric for individual stocks within a market.
In general, a CAPE ratio of between 10 and 15 is considered ideal, while a ratio over 20 could indicate that the market is overvalued and could be due for a correction. It’s worth noting, however, that different markets have different absolute readings, so investors should also take a look at the bigger picture charts.
Many investors prefer to use the CAPE ratio to screen for countries or industries that are trading at a discounted valuation, and then they look for compelling individual opportunities within those countries using American Depositary Receipts (“ADRs”) or by purchasing foreign stocks directly.
Limitations of the CAPE Ratio
As with most financial ratios, investors should use the CAPE ratio in conjunction with other forms of analysis rather than relying on it exclusively. Knowing how a stock price compares to the underlying value is important, but it doesn't tell the whole story about the security or the broader market. A company's stock could be cheap, but if the broader market is in a downturn, the stock price could continue to fall regardless of whether it's cheap or expensive.
Another limitation is that the CAPE ratio requires at least 10 years of historical data, and not all countries have that kind of data readily available. It may be easy to find detailed financial info from companies in the U.S., U.K., Canada, and Japan, but looking up detailed market info may not be as easy when it comes to Austria, China, or Colombia.
- The cyclically adjusted price-to-earnings (CAPE) ratio measures the price of a stock or market index compared to the past 10 years of earnings.
- The CAPE ratio can help ensure that potential long-term returns will be sufficient.
- Investors in frontier and emerging markets face much higher risks than domestic markets given political and currency risk factors, which is why they may use the CAPE ratio to help find good long-term investments.
- Investors should use the CAPE ratio in conjunction with other forms of analysis rather than relying on it exclusively.