CAPE Ratio: Definition & Formula

KEY TAKEAWAYS

• The CAPE ratio is a valuation metric used to measure an overvalued or undervalued stock market.
• It’s calculated by dividing the price of a stock by the average earnings per share over the past 10 years.
• A high CAPE ratio indicates that stocks are expensive relative to earnings. A low CAPE ratio indicates that they are cheap.

What is a CAPE Ratio?

The CAPE ratio, or cyclically-adjusted price-earnings ratio, is a measure of stock market valuation. It’s calculated by dividing the price of a stock by the average earnings per share over the past 10 years

The purpose of the CAPE ratio is to smooth out the effects of business cycle fluctuations on earnings. This makes it a more reliable measure of market valuation than the conventional price-earnings ratio.

A high CAPE ratio indicates that stocks are expensive relative to earnings, while a low CAPE ratio indicates that they are cheap.

The current CAPE ratio for the US stock market is around 32, which is well above its long-term average of 16. This suggests that stocks are currently expensive.

The CAPE ratio is a useful tool for long-term investors. It can help them to identify whether stocks are currently overvalued or undervalued. However, it is important to remember that the CAPE ratio is not a perfect predictor of future earnings potential.

If you’re thinking about investing in the stock market, be sure to do your research and consult with a financial advisor to get started. In the meantime, feel free to read on to find out more about this investment metric.

As you’ll see, it certainly has its strengths that investors can use to their advantage. But like many other valuation measures, it doesn’t tell you everything about stocks. It’s important to use other methods for determining key data.

In any investment venture, you want to gather as much information as you possibly can. In doing so, you will paint a more complete picture of the investment. This can help you avoid market crashes and get the best stock price.

CAPE Ratio – Formula

The CAPE ratio formula is as follows:

CAPE Ratio – Calculation

You calculate CAPE ratio by dividing the price of a stock by the average earnings per share over the past 10 years.

For example, if a company’s stock price is $100 and its earnings per share over the past 10 years have averaged $10, then its CAPE ratio would be 100/10, or 10.

What Does the CAPE Ratio Indicate?

A high CAPE ratio indicates that stocks are expensive relative to earnings, while a low CAPE ratio indicates that they are cheap.

The current CAPE ratio for the US stock market is around 32, which is well above its long-term average of 16. This suggests that stocks are currently expensive.

So, is CAPE ratio helpful to long-term investors? Absolutely. It can help them identify overvalued or undervalued stocks. But it’s important to remember that the CAPE ratio is not a perfect predictor of future stock market returns.

Drawbacks of CAPE Ratio

The CAPE ratio has come under criticism in recent years for a number of reasons.

As a market diversification algorithm, it only looks at stock prices and earnings. It doesn’t take into account other important factors, such as company debt levels or economic growth. As such, you shouldn’t use it for market predictions. 

Second, the 10-year time frame used in the calculation can be misleading. It includes data from both before and after the global financial crisis of 2008. The current CAPE ratio may not reflect prospective long-term stock market returns.

Finally, some critics argue that the CAPE ratio is simply too high right now. And that a stock market crash is inevitable. While this is certainly possible, it’s important to remember that no one can predict the future with 100% accuracy.

Even when looking at historic earnings, you can’t determine what the real earnings will be. Even the most seasoned stock market watcher can’t foresee market forces that affect returns of stock markets.

It’s true that there are peak period earnings. But this isn’t a reliable average of earnings long-term. The bottom line is that the CAPE ratio can be a useful tool for long-term investors. But it’s important to understand its limitations before making any investment decisions.

When evaluating the stock market, it’s always important to consider a variety of factors, not just one metric. Always consult with a financial advisor before making any major investment decisions.

CAPE Ratio – Example

Let’s say you’re considering investing in Company XYZ. You research the company and find that its stock price is $100 and its earnings per share over the past 10 years have averaged $10. This gives it a CAPE ratio of 100/10, or 10.

You then compare this to the current level of CAPE for the US stock market, which is 32. This suggests that stocks are currently expensive and Company XYZ may be overvalued.

However, you also know that the CAPE ratio is not a perfect predictor of market return forecasts. So you have to use other accounting principles to make an informed decision. 

Also keep in mind that economic cycle influences can affect risks to valuations. This will give you a clearer picture of market reality. 

Summary

The CAPE ratio is a useful tool for long-term investors. It can help them to identify whether stocks are currently overvalued or undervalued. However, it is important to remember that the CAPE ratio is not a perfect predictor of future stock market performance.