CAPE

A valuation metric using real EPS over a 10-year period to smooth out business cycle fluctuations.

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio, also known as the Shiller P/E ratio, is a valuation metric used to assess whether a stock market index is overvalued, undervalued, or fairly priced. Traditional price-to-earnings ratios rely on trailing or forward twelve-month earnings, which can fluctuate wildly depending on where the economy sits in the business cycle. CAPE solves this volatility by using a ten-year average of inflation-adjusted earnings per share, smoothing out short-term economic booms and busts to reveal a clearer picture of long-term corporate profitability. To calculate the CAPE ratio, historical earnings per share (EPS) over the past ten years are adjusted for inflation using a consumer price index. These ten years of real earnings are averaged to establish a baseline "cyclically adjusted" earnings figure. The current price of the market index is then divided by this ten-year average. This methodology ensures that a temporary surge in corporate profits during an economic peak, or a temporary plunge during a recession, does not distort the valuation multiple. Investors care about the CAPE ratio because it has historically served as a strong predictor of long-term equity returns. A exceptionally high CAPE ratio relative to historical averages suggests that stock prices have outpaced sustainable earnings power, which often precedes lower future returns over the subsequent decade. Conversely, a low CAPE ratio indicates potential undervaluation and higher long-term return prospects. However, critics note that changes in accounting standards, corporate payout policies like stock buybacks, and prolonged low-interest-rate environments can permanently shift the baseline, making historical comparisons less direct.

Suppose the S&P 500 index is currently trading at 4,500. Over the past 10 years, the annual earnings per share of the index are adjusted for inflation to current dollars. The sum of these 10 years of inflation-adjusted earnings is $1,500, which yields a 10-year average inflation-adjusted EPS of $150 ($1,500 / 10). The CAPE ratio is calculated as 4,500 / 150 = 30.0x.