DEFINITION of 'CAPE Ratio'

The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. The ratio is generally applied to broad equity indices to assess whether the market is undervalued or overvalued. While the CAPE ratio is a popular and widely-followed measure, several leading industry practitioners have called into question its utility as a predictor of future stock market returns.

The CAPE ratio, an acronym for Cyclically Adjusted P/E (i.e. Price-Earnings) ratio, was popularized by Yale University professor Robert Shiller.

It is also known as the Shiller P/E ratio.

BREAKING DOWN 'CAPE Ratio'

A company’s profitability is determined to a significant extent by the economic cycle. During expansions, profits rise substantially as consumers spend with abandon, but during recessions, profits plunge and often turn into losses. While profit swings are much larger for companies in cyclical sectors – such as commodities and financials – than they are for firms in defensive sectors such as utilities and pharmaceuticals, few companies can maintain steadfast profitability in the face of a deep recession. Because volatility in per-share earnings also results in price-earnings (P/E) ratios that bounce around too much, Benjamin Graham and David Dodd recommended in their seminal 1934 book, Security Analysis, that for examining valuation ratios, one should use an average of earnings over preferably seven or ten years.

The Cyclically Adjusted Price-Earnings (CAPE) ratio initially came into the spotlight in December 1996, after Robert Shiller and John Campbell presented research to the Federal Reserve that suggested stock prices were running up much faster than earnings. In the winter of 1998, Shiller and Campbell published their groundbreaking article Valuation Ratios and the Long-Run Stock Market Outlook, in which they smoothed earnings for the S&P 500 by taking an average of real earnings over the past 10 years, going back to 1872.

This ratio was at a record 28 in January 1997, with the only other instance (at that time) of a comparably high ratio occurring in 1929. Shiller and Campbell asserted the ratio was predicting that the real value of the market would be 40% lower in ten years than it was at that time. That forecast proved to be remarkably prescient, as the market crash of 2008 contributed to the S&P 500 plunging 60% from October 2007 to March 2009.

The CAPE ratio for the S&P 500 climbed steadily in the second decade of this millennium as the economic recovery in the U.S. gathered momentum and stock prices reached record levels. As of October 2017, the CAPE ratio stood at 31.21, compared with its long-term average of 16.80. The fact that the ratio had previously only exceeded 30 in 1929 and 2000 triggered a raging debate about whether the elevated value of the ratio portends a major market correction.

Critics of the CAPE ratio contend that it is of little use because it is inherently backward-looking, rather than forward-looking. Another issue is that it uses GAAP (generally accepted accounting principles) earnings, which have undergone marked changes in recent years. In June 2016, Jeremy Siegel of the Wharton School published a paper in which he said that forecasts of future equity returns using the CAPE ratio may be overly pessimistic because of changes in the way GAAP earnings are calculated. Siegel said that using consistent earnings data such as operating earnings or NIPA (national income and product account) after-tax corporate profits, rather than GAAP earnings, improves the forecasting ability of the CAPE model and forecasts higher U.S. equity returns. 

RELATED TERMS
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  2. Cape Cod Method

    Cape Cod method is used to calculate loss reserves that uses ...
  3. Price/Earnings To Growth - PEG ...

    Price/Earnings to Growth (PEG) is a stock's price to earnings ...
  4. CVE

    CVE is the ISO 4217 currency code for the Cape Verde escudo, ...
  5. Accounting Ratio

    Accounting ratios, also known as financial ratios, are used to ...
  6. P/E 30 Ratio

    P/E 30 ratio means that a company's stock price is trading at ...
Related Articles
  1. Insights

    Is the CAPE Ratio Predicting an Era of Low Returns?

    When the the CAPE ratio is high, as it is now, it can indicate a bubble economy nearing its peak. Are we headed towards another bust?
  2. Investing

    Stock Valuations Highest Since 1929 Crash, Dotcom Bubble

    U.S. stocks have same lofty valuations as when Greenspan warned of "Irrational Exuberance" in 1996.
  3. Investing

    Why The 1929 Stock Market Crash Could Happen In 2018

    Sound the alarm: per Nobel Laureate Robert Shiller's CAPE ratio, U.S. stocks are pricier than before the 1929 crash.
  4. Insights

    Will Policy Uncertainty Index Doom Trump's Rally?

    Nobel Laureate Robert Shiller says soaring uncertainty regarding Trump's policies is a danger sign
  5. Insights

    5 Indicators of An Overvalued Stock Market

    These five financial indicators show that the stock market is alarmingly overvalued.
  6. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  7. Investing

    Investors Face 'Pain' In Highest Stock, Bond Values Since 1900

    Bear market ahead: stocks, bonds and credit are at their highest average valuation since 1900.
  8. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  9. Investing

    5 must-have metrics for value investors

    In this article, we outline the five ratios that can help value investors find the most undervalued stocks in the market.
  10. Investing

    How Do I Calculate the Price-Earnings Ratio?

    If Apple is trading at $108.73 per share, and its trailing twelve months' EPS is $6.45, calculate the P/E ratio as...
RELATED FAQS
  1. What is considered a good PEG (price to earnings growth) ratio?

    Learn about the price/earnings to growth (PEG) ratio and understand what investors and market analysts consider a good ratio ... Read Answer >>
  2. What is the difference between efficiency ratios and profitability ratios?

    Learn about efficiency and profitability ratios, what these ratios measure and the main difference between efficiency and ... Read Answer >>
Hot Definitions
  1. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  2. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  3. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  4. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  5. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  6. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
Trading Center