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CAPE Ratio Definition
The CAPE ratio is defined as a price earnings ratio that measures the average of adjusted earnings over a period of 10 years. It is a price valuation method that determines the real earnings per share (EPS) over a period of 10 years which is adjusted for inflation.
The CAPE ratio is an acronym for the cyclically adjusted price-to-earnings ratio, otherwise called the Shiller P/E ratio. The CAPE ratio has been widely adopted across various industries and it gives a projection of future stock market returns in the Stock Exchange market.
A professor at Yale University, Robert Shiller popularized the cyclically adjusted price-to-earnings ratio (CAPE ratio) and this is why the ratio is also called the Shiller P/E ratio.
The formula for calculating CAPE ratio is;
CAPE Ratio = Share Price / 10-yr Avg. Inflation-Adjusted Earnings
A Little More on What is the CAPE Ratio
In the United States, the CAPE ratio is used as a valuation method for the US S&P 500 market index. Companies and industries in the US also use the CAPE ratio to determine their inflation-adjusted earnings which how fluctuations in profits over a period of time affect their real earnings. There are many reasons fluctuations in corporate profit may occur, such as changes in the purchase power of consumers, inflations, recessions and downturn in demand. These fluctuations significantly impede the profitability of a company or industry.
The CAPE ratio is a valuation ratio that helps determine volatility in earnings per share that occur over a period of ten years.
Here are some important things to note about the CAPE ratio;
- The CAPE ratio is an acronym for the cyclically adjusted price-to-earnings ratio, it was popularized by Robert Shiller, a professor at Yale university.
- The CAPE ratio evaluates the financial performance of a company over a period of ten years with effects of fluctuations and inflations on the company’s earnings taken into account.
- The CAPE ratio is also used in the stock exchange ,market to determine whether a stock is undervalued or overvalued.
- This ratio measured that average earning per share of a company which is adjusted for inflation and calculated over a period of 10 years.
Reference for “CAPE ratio”
Academic research on “CAPE ratio”
The Shiller CAPE ratio: A new lookSiegel, J. J. (2016). The Shiller CAPE ratio: A new look. Financial Analysts Journal, 72(3), 41-50. Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.
Reducing sequence risk using trend following and the CAPE ratioClare, A., Seaton, J., Smith, P. N., & Thomas, S. (2017). Reducing sequence risk using trend following and the CAPE ratio. Financial Analysts Journal, 73(4), 91-103. The risk of experiencing bad investment outcomes at the wrong time, or sequence risk, is a poorly understood but crucial aspect of the risk investors face—particularly those in the decumulation phase of their savings journey, typically over the period of retirement financed by a defined contribution pension scheme. Using US equity return data for 1872–2014, we show how this risk can be significantly reduced by applying trend-following investment strategies. We also show that knowing a valuation ratio, such as the cyclically adjusted price-to-earnings (CAPE) ratio, at the beginning of a decumulation period is useful for enhancing sustainable investment income.