Price Earnings Ratio: The Cyclically Adjusted P/E Ratio

Today, we’re presenting a technical discussion on an interesting investment concept, care of Manshu Verma from One Mint, an investment blog that covers topics ranging from Indian IPOs to U.S. ETFs, and everything in between.

Cyclically Adjusted P/E Ratio (CAPE) is an enhanced way of calculating the P/E ratio which considers the average inflation adjusted earnings of a company over the last 10 years. This smoothens out the fluctuations in earnings that occur from one year to the next, while still giving a sense of how high or low the price of a particular stock is.

To understand how CAPE is calculated, we need to take a look at how P/E Ratio is calculated first.

Price to Earnings Ratio considers two things:

* Market price of the stock.
* Earnings Per Share or EPS of the company.

P/E Ratio is calculated by dividing the market price by the earnings per share of the company.

P/E = Market Price / Earnings Per Share

EPS can be last year’s earnings or even the projected earnings for the next year. CAPE takes the average earnings of the last ten years and adjusts it for inflation: this smoothens out the fluctuations in earnings due to booms and busts, which occur from one year to another.

CAPE was originally developed by Benjamin Graham, and has been used by various analysts since then; the most notable proponent has been Professor Robert Shiller of Yale University. You can find data on CAPE on Professor Shiller’s website.

In this interview, Prof. Shiller states that the highest CAPE ratio in the US market has been 46 during the boom of 2000, and the average CAPE has been 15. Also in the interview, Prof. Shiller makes two very interesting points.

1. Mean Reversion: The first is about mean reversion: if CAPE is higher than the average of 15, and certainly, when it is as high as 46, it is quite likely to revert to the mean — and come back to 15. The same is true in reverse also; when the market is trading below the average CAPE, it is likely to move higher. So, that means it is a fairly good indicator to know which direction the market is headed.

2. No one knows when it will turn around: If you want to time the market or predict market direction, knowing that the CAPE is below or above the mean is not good enough. You really need to know when it will turn. If it is at 10, mean reversion indicates that it should go back to 15 — but that doesn’t mean that it can’t go to 6 first. So, there is no way to know the exact bottom of the market, and trying to predict that is like catching a falling knife.

I personally think that this measure is pretty useful for helping us gauge extremes. While there is no way to predict the top or the bottom of a stock’s (or market’s) price — you certainly don’t want to be buying a stock when its CAPE is at 46, and you don’t want to be selling a stock when the P/E ratio is at 6!

(Thanks to Smart Wallet)