CAPE Ratio

Definition

The CAPE Ratio, or Cyclically Adjusted Price-to-Earnings Ratio, is a valuation metric used to assess the long-term performance of stocks. It is calculated by dividing a stock’s current price by its average inflation-adjusted earnings over the past ten years. The ratio helps investors gauge a stock’s current price relative to its historical earnings, enabling them to make informed decisions on whether a stock is overvalued or undervalued.

Phonetic

The phonetics of the keyword “CAPE Ratio” is: ˈkeɪp ˈreɪʃiˌoʊ

Key Takeaways

1. CAPE Ratio, also known as Cyclically Adjusted Price-to-Earnings Ratio or Shiller P/E Ratio, is a valuation metric for stocks that takes into account the inflation-adjusted earnings for the past ten years. Unlike the traditional P/E Ratio, CAPE Ratio helps to understand the long-term trends in the market.
2. CAPE Ratio can be helpful to identify overvalued or undervalued markets, allowing investors to make informed decisions regarding their investments. A high CAPE Ratio typically suggests that the market is overvalued, whereas a low CAPE Ratio may indicate that the stocks are undervalued.
3. While the CAPE Ratio can provide valuable insights for long-term investment strategies, it’s essential to note that it doesn’t predict short-term variations or individual stock performances. Moreover, the CAPE Ratio may not be as effective in markets with rapidly changing dynamics or during times of extreme market volatility.

Importance

The CAPE (Cyclically Adjusted Price to Earnings) Ratio is an important financial metric in business and finance as it provides a more comprehensive view of a company’s or market’s valuation by considering earnings data from a longer time period, typically 10 years. This takes into account economic cycles and reduces the impact of short-term fluctuations, resulting in a more reliable indicator of the intrinsic value of a company or market. As a result, the CAPE Ratio enables investors to assess the long-term potential of a stock and make better investment decisions, helping them identify overvalued or undervalued stocks and thus optimize their portfolio’s risk and return.

Explanation

The CAPE (Cyclically Adjusted Price-to-Earnings) ratio is an essential valuation tool used by finance and business professionals to gain a more comprehensive understanding of a company or market’s valuation in relation to its earnings. Purposefully designed to provide a long-term perspective, the CAPE ratio measures the price of a stock or index in comparison to its average earnings over a period of time, typically ten years, adjusted for inflation. The key aim of this tool is to eliminate the effects of economic cycles and provide investors with a more accurate evaluation of the company’s intrinsic value. As a result, it enables investors to make better-informed decisions and identify potential opportunities for long-term investments.

Using the CAPE ratio, investors and analysts can compare the current valuation of a company or index to historical averages, providing insight into whether it may be over or under-valued in the current economic climate. For instance, a high CAPE ratio may indicate that stocks are expensive and could potentially be subjected to a future correction, while a low CAPE ratio could suggest that stocks are currently undervalued. Additionally, the CAPE ratio can be employed as a forecasting tool, as analysts may use this metric to compare across different countries or industries to identify relatively attractive investment options. It is, however, essential to recognize that the CAPE ratio should not be used as a sole determinant in investment decision-making, as it is bolstered when combined with other fundamental analysis tools and macroeconomic factors.

Examples

The CAPE Ratio, or Cyclically Adjusted Price-to-Earnings Ratio, is a valuation method used to judge the relative value of stocks or the broader market by comparing the current market price to the average earnings over the past ten years, adjusted for inflation. It helps to understand the market’s historical trends and make informed decisions about investments or potential market bubbles. Here are three real-world examples:

1. US Stock Market in 2000:At the peak of the dot-com bubble in December 1999, the CAPE ratio for the S&P 500 index reached an all-time high of 44.2, well above its long-term historical average (which usually hovers around 17). This high ratio indicated that the market was overvalued, and investors should exercise caution. As we know, the subsequent bursting of the dot-com bubble led to a significant stock market decline by 2002.

2. Japanese Stock Market in 1989:In the late 1980s, Japan experienced an asset bubble in its stock and real estate markets. At its peak in December 1989, the CAPE ratio for the Nikkei 225 index was around 95, an extremely high number that pointed to an overvalued market. The eventual collapse of the Japanese asset prices in the early 1990s resulted in a prolonged period of slow economic growth, known as the “Lost Decade.”

3. European Financial Crisis in 2011:Amidst the 2011 European financial crisis, some European stock markets were trading at historically low CAPE ratios. For example, in September 2011, the CAPE ratio for the German DAX index was at 11.85, while the CAPE ratio for the French CAC 40 index was at 10.52. These low ratios suggested that European stocks were undervalued in comparison to their historical standards, and thus presented a potential buying opportunity for long-term investors who believed in the recovery of the European economy. Over the following years, the European markets rebounded as the crisis was resolved.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Cyclically Adjusted Price to Earnings
• Robert Shiller
• Price to Earnings Ratio (P/E)
• Stock Market Valuation
• 10-Year Average Earnings

Sources for More Information

• Investopedia
• Seeking Alpha: S&P 500 CAPE Ratio
• Corporate Finance Institute
• Wikipedia