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. P/E 10 Ratio

    The P/E 10 ratio is a valuation measure, generally applied to ...
  2. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  3. Graveyard Market

    A graveyard market reflects prolonged bearish sentiment. Existing ...
  4. Accounting Ratio

    Accounting ratios, also known as financial ratios, are used to ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  6. Operating Ratio

    The operating ratio shows the efficiency of a company's management ...
Related Articles
  1. Investing

    Why the Stock Bubble Will Burst Quickly: Yale's Shiller

    Nobel Laureate Robert Shiller warns that stocks could tumble suddenly and unexpectedly.
  2. Investing

    Stocks Could Rise 50%, Says Yale's Shiller

    Robert Shiller, a nobel-winning economist, has predicted that the bull market could last several years.
  3. Insights

    Will Policy Uncertainty Index Doom Trump's Rally?

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

    Analyze Investments Quickly With Ratios

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

    Sysco and Other Big Movers In Services

    The market has been slipping so far today. The Nasdaq has fallen 0.3%; the S&P 500 has fallen 0.4%; and the Dow has declined 0.5%. The Services sector (IYC) is currently lagging behind the overall ...
  6. 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.
  7. 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 ...
  8. Investing

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  9. 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. Why do shareholders need financial statements?

    Discover the importance of a company's financial statements for stock shareholders in evaluating their equity investment ... Read Answer >>
  2. How does ratio analysis make it easier to compare different companies?

    Learn what ratio analysis is, how investors can compare companies within the same sector using ratio analysis and how ratios ... Read Answer >>
  3. When computing the PEG ratio for a stock, how is a company's earnings growth rate ...

    Remember that the price/earnings to growth ratio (PEG ratio) is simply a given stock's price/earnings ratio (P/E ratio) divided ... Read Answer >>
  4. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  5. What does the forward p/e indicate about a company?

    Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ... Read Answer >>
  6. What is the expense ratio in the insurance industry?

    Understand the two different methods of calculating expense ratio and find out how it can be used to compare insurance companies ... Read Answer >>
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center