CAPE Ratio

Introduction: What is CAPE Ratio and Why is it Important for Investors?

Understanding the Cyclically Adjusted Price-to-Earnings Ratio (CAPE Ratio): A Key Metric for Investors

As an investor, you're always looking for ways to make informed decisions about your portfolio. You may have heard about various financial metrics and ratios that can help you gauge the value of a company or the overall market. One such metric is the cyclically adjusted price-to-earnings ratio, or CAPE ratio. Developed by economist Robert Shiller, the CAPE ratio is a measure of market valuation that takes into account long-term earnings trends, rather than just current earnings. In this article, we'll dive deep into the concept of CAPE ratio, explore how it's calculated and used in practice, and discuss its importance for investors.

We'll also dwelve into the limitations of CAPE ratio and look at some examples of how it's used in action. By the end of this article, you'll have a solid understanding of CAPE ratio and how it can help you make more informed investment decisions.

How is CAPE Ratio Calculated?

To calculate the CAPE ratio, an investor first needs to determine the average inflation-adjusted earnings per share (EPS) for a company over the past 10 years. This is done by taking the average of the EPS for each year over the past decade, adjusted for inflation using the Consumer Price Index (CPI). Next, the investor divides the current price per share of the company's stock by the average inflation-adjusted EPS. The result is the CAPE ratio for the company.

Some examples

For example, let's say that Company XYZ has an EPS of $5 in 2012, $6 in 2013, $7 in 2014, and so on, for a total of 10 years. If the CPI for 2012 is 100, the CPI for 2013 is 105, and so on, the average inflation-adjusted EPS for XYZ over the past decade would be calculated as follows:

(($5 x 100) + ($6 x 105) + ($7 x 110) + … + ($10 x 150)) / 10 = $7.50

If the current price per share of XYZ's stock is $100, the CAPE ratio would be calculated as follows:

$100 / $7.50 = 13.33

What Does CAPE Ratio Tell Investors?

The CAPE ratio is often used as a measure of market valuation, as it takes into account long-term earnings trends rather than just current earnings. A high CAPE ratio may indicate that a company's stock is overvalued, as it suggests that the price is high relative to the company's historical earnings. On the other hand, a low CAPE ratio may indicate that a company's stock is undervalued, as it suggests that the price is low relative to the company's historical earnings. However, it's important to note that the CAPE ratio is not a perfect measure of valuation, as it has some limitations and should be used in conjunction with other metrics.

What are the Limitations of CAPE Ratio

While the CAPE ratio can be a useful tool for investors, it has some limitations that should be considered. One limitation is that the CAPE ratio is based on historical earnings, which may not accurately reflect the company's future earnings potential. Additionally, the CAPE ratio is sensitive to changes in the CPI, which can affect the inflation-adjusted EPS and the overall ratio. Finally, the CAPE ratio is a broad measure that takes into account the earnings of the entire market, rather than just individual companies. As a result, it may not accurately reflect the valuation of a specific company.

Examples of CAPE Ratio in Action

To better understand the concept of CAPE ratio and how it's used in practice, let's look at a couple of examples:

• Example 1: Company ABC has an EPS of $10 in 2012, $12 in 2013, $14 in 2014, and so on, for a total of 10 years. If the CPI for 2012 is 100, the CPI for 2013 is 105, and so on, the average inflation-adjusted EPS for ABC over the past decade would be calculated as follows:

(($10 x 100) + ($12 x 105) + ($14 x 110) + … + ($20 x 150)) / 10 = $12.50

If the current price per share of ABC's stock is $100, the CAPE ratio would be calculated as follows:

$100 / $12.50 = 8

In this example, the CAPE ratio for ABC is 8, which is lower than the average CAPE ratio of the market. This may indicate that ABC's stock is undervalued, as the price is low relative to the company's historical earnings. However, it's important to consider other factors, such as the company's future earnings potential, when making an investment decision.

• Example 2: Company XYZ has an EPS of $5 in 2012, $6 in 2013, $7 in 2014, and so on, for a total of 10 years. If the CPI for 2012 is 100, the CPI for 2013 is 105, and so on, the average inflation-adjusted EPS for XYZ over the past decade would be calculated as follows:

(($5 x 100) + ($6 x 105) + ($7 x 110) + … + ($10 x 150)) / 10 = $7.50

If the current price per share of XYZ's stock is $100, the CAPE ratio would be calculated as follows:

$100 / $7.50 = 13.33

In this example, the CAPE ratio for XYZ is 13.33, which is higher than the average CAPE ratio of the market. This may indicate that XYZ's stock is overvalued, as the price is high relative to the company's historical earnings. Again, it's important to consider other factors, such as the company's future earnings potential, when making an investment decision.

Conclusion – The Future of CAPE Ratio: A Valuable Tool for Investors in a Dynamic Market

The CAPE ratio is a valuable tool for investors looking to make informed decisions about their portfolios. By taking into account long-term earnings trends, the CAPE ratio can provide valuable insights into market valuation and help investors identify opportunities for growth and value. While it has some limitations, the CAPE ratio can be a useful addition to an investor's toolkit, especially in a dynamic market where staying ahead of the curve is key.