What is the P/E 10 Ratio
The P/E 10 ratio is a valuation measure, generally applied to broad equity indices, that uses real per-share earnings over a 10-year period. The P/E 10 ratio uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle.
The P/E 10 ratio is also known as the Cyclically Adjusted Price Earnings (CAPE) ratio or the Shiller PE ratio.
BREAKING DOWN P/E 10 Ratio
The ratio was popularized by Yale University professor Robert Shiller, author of the bestseller "Irrational Exuberance," who won the Nobel Prize in Economic Sciences in 2013. Shiller attracted a great deal of attention after he warned that the frenetic U.S. stock market rally of the late-1990s would turn out to be a bubble. The P/E 10 ratio is based on the work of renowned investors Benjamin Graham and David Dodd in their legendary 1934 investment tome "Security Analysis." They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. To smooth a firm's earnings over a period of time, Graham and Dodd recommended using a multi-year average of earnings per share (EPS) — such as five, seven or 10 years — when computing P/E ratios.
Calculating the P/E 10 Ratio
The P/E 10 ratio is calculated as follows: take the annual EPS of an equity index, such as the S&P 500, for the past 10 years. Adjust these earnings for inflation using the Consumer Price Index (CPI), that is, adjust past earnings to today's dollars. Take the average of these real EPS figures over the 10-year period. Divide the current level of the S&P 500 by the 10-year average EPS number to get the P/E 10 ratio or CAPE ratio.
The P/E 10 ratio varies a great deal over time. According to data first presented in "Irrational Exuberance" (which was released in March 2000, coinciding with the peak of the dotcom boom), updated to cover the period 1881 to November 2013, the ratio has varied from a low of 4.78 in December 1920 to a high of 44.20 in December 1999. As of 2017, the historic P/E 10 average was 16.7.
Using market data from both estimated (1881–1956) and actual (1957 onward) earnings reports from the S&P index, Shiller and John Campbell found that the lower the CAPE, the higher the investors' likely return from equities over the following 20 years.
Shortfalls of the P/E 10 Ratio
A criticism of the P/E 10 ratio is that it is not always accurate in signaling market tops or bottoms. For example, an article in the September 2011 issue of the American Association of Individual Investors Journal noted that the CAPE ratio for the S&P 500 was 23.35 in July 2011. Comparing this ratio to the long-term CAPE average of 16.41 would suggest that the index was more than 40% overvalued at that point. The article suggested that the CAPE ratio provided an overly bearish view of the market, since conventional valuation measures like the P/E showed the S&P 500 trading at a multiple of 16.17 (based on reported earnings) or 14.84 (based on operating earnings). Although the S&P 500 did plunge 16% during a one-month span from mid-July to mid-August 2011, the index subsequently rose more than 35% from July 2011 to new highs by November 2013.