Understanding the CAPE Ratio: A Guide to Cyclically Adjusted P/E

The CAPE Ratio (also known as the Shiller P/E or PE 10 Ratio) is an acronym for the Cyclically-Adjusted Price-to-Earnings Ratio. The ratio is calculated by dividing a company’s stock price by the average of the company’s earnings for the last ten years, adjusted for inflation.

Financial AnalystsWorld-Class Financial AnalystA world-class financial analyst has a unique combination of skills that enable them to have an enormous positive impact on an organization. Top skills are being able to analyze both quantitative and qualitative data, understanding detailed and big picture thinking, balancing simplicity and complexity use the Cyclically-Adjusted Price to Earnings Ratio to assess long-term financial performance, while isolating the impact of economic cycles.

Learn more about Financial Ratio with CFI’s Financial Analysis Fundamental Course

The CAPE ratio is a variation of the Price-to-Earnings (P/E) ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio is the relationship between a company’s stock price and earnings per share. It provides a better sense of the value of a company.. Similar to the P/E ratio, the CAPE ratio aims to indicate whether a stock is undervalued or overvalued.

The CAPE ratio allows the assessment of a company’s profitability over different periods of an economic cycle. The ratio also considers economic fluctuations, including the economy’s expansion and recession. Essentially, it provides a broader view of a company’s profitability by smoothing out the cyclical effects of the economy.

The CAPE ratio was derived by Robert Shiller, an American economist and Nobel Prize Laureate in economics.

CAPE Ratio and Market Crashes

An extremely high CAPE ratio means that a company’s stock price is substantially higher than the company’s earnings would indicate and, therefore, overvalued. It is generally expected that the market will eventually correct the company’s stock price by pushing it down to its true value.

In the past, the CAPE ratio has proved its importance in identifying potential bubbles and market crashes. The historical average of the ratio for the S&P 500 Index is between 15-16, while the highest levels of the ratio have exceeded 30. The record-high levels occurred three times in the history of the U.S. financial markets. The first was in 1929 before the Wall Street crash that signaled the start of the Great Depression.The Great DepressionThe Great Depression was a worldwide economic depression that took place from the late 1920s through the 1930s. For decades, debates went on about what caused the economic catastrophe, and economists remain split over a number of different schools of thought. The second was in the late 1990s before the Dotcom Crash, and the third came in 2007 before the 2007-2008 Financial Crisis.

Learn more about Financial Ratio with CFI’s Financial Analysis Fundamental Course

CAPE Ratio in Forecasting

There is believed to be a relationship between the CAPE ratio and future earnings. Shiller concluded that lower ratios indicate higher returns for investors over time.

However, there are criticisms regarding the use of the CAPE ratio in forecasting earnings. The main concern is that the ratio does not take into account changes in accounting reporting rules. For example, recent changes in the calculation of earnings under the GAAPGAAPGAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial distort the ratio and provide an overly pessimistic view of future earnings.

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following CFI resources:

• Financial RatiosFinancial RatiosFinancial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company
• Guide to Financial ModelingFree Financial Modeling GuideThis financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
• Projecting Balance Sheet Line ItemsProjecting Balance Sheet Line ItemsProjecting balance sheet line items involves analyzing working capital, PP&E, debt share capital and net income. This guide breaks down how to calculate
• Financial Analysis Ratios GlossaryFinancial Analysis Ratios GlossaryGlossary of terms and definitions for common financial analysis ratios terms.  It's important to have an understanding of these important terms.