All About Cape Ratio

CAPE Ratio Explained

As a way to determine the merit of an investment, investors often look at the P/E ratio. The P/E ratio, which is a measure of the earning per share, tells investors how profitable an investment option. The CAPE ratio, a valuation measure that calculates real P/E over ten years to smooth out fluctuations in company profit due to the business cycle, is used. CAPE stands for cyclically adjusted profit-to-earnings ratio. This ratio is also known as the Shiller P/E Ratio after Robert Shiller, an American economist and Nobel laureate who popularized CAPE.

Let's first discuss Shiller P/E.

The P/E ratio, a valuation metric, compares the current stock price to the company's earnings-per-share (EPS). Analysts and investors use the P/E ratio to assess the relative value of a company's shares. This is how they determine whether it is undervalued or overvalued. High P/E rates indicate that shares of company are highly valued. Companies that are losing money or have no income won't have a high P/E ratio. Historical data is crucial in calculating the P/E.

Below is the formula that was used to calculate Shiller's P/E ratio

The CAPE Ratio is used by financial analysts to assess a company's long-term performance and the effect of changes in the business cycle. Experts disagree with the widespread use of CAPE Ratio. They claim it can't accurately predict future stock returns.

What does the Shiller P/E Ratio tell you?

The CAPE ratio is a variation of the P/E ratio but cyclically adjusted. It is similar to the P/E ratio and can be used to determine if a stock has been over- or undervalued.

The CAPE ratio measures a company's profit ratio over a time period at different stages in an economic cycle. It takes into account economic fluctuations, such as expansion and contraction. This gives a wider picture of a company's performance, smoothing out any cyclical effects. In their 1934 book, Benjamin Graham and David Dodd noted that a valuation ratio can be calculated over a longer period to provide better clarity. How do you calculate valuation ratio?

Over time, profit of a company fluctuates. Profitability rises when there is economic expansion because consumers spend more money. In times of economic contraction, profitability rises because consumers spend more money. This causes company profits to plummet. Companies in the cyclical industry like automobiles, consumer durables and finance are more affected by economic cycles than those in the defensive sector, such as FMCG, utilities or pharmaceuticals. The CAPE ratio is a measure of economic factors that impact a firm's profit. It provides insight into its long-term performance.

Market Prediction

Investors and analysts use the company P/E ratio to assess the long-term performance a company. Investors are also warned if stock is too expensive. The CAPE ratio used to warn investors about market crashes and bubbles. The market assumes that the price will eventually return to its original value if the P/E ratio rises. Shiller suggested that investors who have a lower Cape P/E will see a higher return over time.

Criticisms of the CAPE ratio

The CAPE ratio is a tool that helps investors predict the company's future performance. It has its limitations. Experts have noted that the CAPE ratio is not forward-looking as it is based on historical data. The formula also uses GAAP (generally accepted Accounting Principles). Accounting reporting rules have seen significant changes over the years since the formula was created. A CAPE ratio calculated with GAAP principle might not be accurate. Jeremy Seigel also mentioned in his paper, that CAPE ratios calculated using modified GAAP may give an overly optimistic value for future earnings.

Conclusion

The CAPE P/E ratio provides insight into a company's performance over time to help predict its future potential. It is an important valuation method that analysts use to assess the sustainability of a company, ignoring economic fluctuations.