Cyclically adjusted price-to-earnings ratio

Last updated

The cyclically adjusted price-to-earnings ratio , commonly known as CAPE, [1] Shiller P/E, or P/E 10 ratio, [2] is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. [3] As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

Contents

S&P 500 shiller P/E ratio compared to trailing 12 months P/E ratio S&P 500 Shiller P-E Ratio.png
S&P 500 shiller P/E ratio compared to trailing 12 months P/E ratio

The ratio was invented by American economist Robert J. Shiller.

The ratio is used to gauge whether a stock, or group of stocks, is undervalued or overvalued by comparing its current market price to its inflation-adjusted historical earnings record.

It is a variant of the more popular price to earning ratio and is calculated by dividing the current price of a stock by its average inflation-adjusted earnings over the last 10 years.

Using average earnings over the last decade helps to smooth out the impact of business cycles and other events and gives a better picture of a company's sustainable earning power.

It is not intended as an indicator of impending market crashes, although high CAPE values have been associated with such events. [4]

Background

CAPE based on data from economist Robert Shiller's website, as of 8/4/2015. The 26.45 measure was 93rd percentile, meaning 93% of the time investors paid less for stocks overall relative to earnings. SP 500 Price Earnings Ratio (CAPE).png
CAPE based on data from economist Robert Shiller's website, as of 8/4/2015. The 26.45 measure was 93rd percentile, meaning 93% of the time investors paid less for stocks overall relative to earnings.

Value investors Benjamin Graham and David Dodd argued for smoothing a firm's earnings over the past five to ten years in their classic text Security Analysis . Graham and Dodd noted one-year earnings were too volatile to offer a good idea of a firm's true earning power. In a 1988 paper [5] economists John Y. Campbell and Robert Shiller concluded that "a long moving average of real earnings helps to forecast future real dividends" which in turn are correlated with returns on stocks. The idea is to take a long-term average of earnings (typically 5 or 10 year) and adjust for inflation to forecast future returns. The long term average smooths out short term volatility of earnings and medium-term business cycles in the general economy and they thought it was a better reflection of a firm's long term earning power.

From the 1940s, Sir John Templeton used a method adapted from Graham and Dodd, and somewhat similar to the later Shiller P/E, but with the Dow Jones Industrial Index. [6]

Shiller later popularized the 10-year version of Graham and Dodd's P/E as a way to value the stock market as measured by the S&P 500. [2] [7] Shiller would share the Nobel Memorial Prize in Economic Sciences in 2013 for his work in the empirical analysis of asset prices.

Use in forecasting future returns

Using market data from both estimated (1881–1956) and actual (1957 onward) earnings reports from the S&P index, Shiller and Campbell found that the lower the CAPE, the higher the investors' likely return from equities over the following 20 years. The average CAPE value for the 20th century was 15.21; this corresponds to an average annual return over the next 20 years of around 6.6 per cent. CAPE values above this produce corresponding lower returns, and vice versa. In 2014, Shiller expressed concern that the prevailing CAPE of over 25 was "a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks" (ref 4). A high CAPE ratio has been linked to the phrase "irrational exuberance" and to Shiller's book of the same name. After Fed President Alan Greenspan coined the term in 1996, the CAPE ratio reached an all-time high during the 2000 dot-com bubble. It also reached a historically high level again during the housing bubble up to 2007 before the crash of the great recession. [8]

However, Shiller's views on what CAPE value is a predictor of poor returns have been criticized as overly pessimistic and based on the original definition of CAPE, which fails to take into account changes in accounting standards in 1990s, which, according to Jeremy Siegel, produce understated earnings. [9]

The measure exhibits a significant amount of variation over time, and has been criticized as "not always accurate in signaling market tops or bottoms". [2] One proposed reason for this time variation is that CAPE does not take into account prevailing risk-free interest rates. A common debate is whether the inverse CAPE ratio should be further divided by the yield on 10 year Treasuries. [10] This debate regained currency in 2014 as the CAPE ratio reached an all-time high in combination with historically very low rates on 10 year Treasuries.

CAPE for other equity markets

Originally derived for the US equity market, the CAPE has since been calculated for 15 other markets. [11] Research by Norbert Keimling has demonstrated that the same relation between CAPE and future equity returns exists in every equity market so far examined. [12] Research by others has also found CAPE ratios are reliable in estimating market returns over five to ten year periods in many international stock markets. [13] [14] [15]

It also suggests that comparison of CAPE values can assist in identifying the best markets for future equity returns beyond the US market.

See also

Related Research Articles

Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.

Investment is traditionally defined as the "commitment of resources to achieve later benefits". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broader viewpoint, an investment can be defined as "to tailor the pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows". When expenditures and receipts are defined in terms of money, then the net monetary receipt in a time period is termed cash flow, while money received in a series of several time periods is termed cash flow stream.

<span class="mw-page-title-main">Price–earnings ratio</span> Financial Metric

The price–earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company's share (stock) price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be tangible book value.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.

<i>Irrational Exuberance</i> (book) 2000 book by Robert Shiller

Irrational Exuberance is a book by American economist Robert J. Shiller of Yale University, published March 2000. The book examines economic bubbles in the 1990s and early 2000s, and is named after Federal Reserve Chairman Alan Greenspan's famed 1996 comment about "irrational exuberance" warning of such a possible bubble.

<span class="mw-page-title-main">Value investing</span> Investment paradigm

Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham and David Dodd at Columbia Business School in 1928, and subsequently developed in their 1934 text Security Analysis.

The 'PEG ratio' is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth.

Market timing is the strategy of making buying or selling decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market rather than for a particular financial asset.

"Irrational exuberance" is the phrase used by the then-Federal Reserve Board chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the dot-com bubble of the 1990s. The phrase was interpreted as a warning that the stock market might be overvalued.

A real-estate bubble or property bubble is a type of economic bubble that occurs periodically in local or global real estate markets, and it typically follows a land boom. A land boom is a rapid increase in the market price of real property such as housing until they reach unsustainable levels and then declines. This period, during the run-up to the crash, is also known as froth. The questions of whether real estate bubbles can be identified and prevented, and whether they have broader macroeconomic significance, are answered differently by schools of economic thought, as detailed below.

<span class="mw-page-title-main">Fed model</span> Disputed equity valuation model

The "Fed model", or "Fed Stock Valuation Model" (FSVM), is a disputed theory of equity valuation that compares the stock market's forward earnings yield to the nominal yield on long-term government bonds, and that the stock market – as a whole – is fairly valued, when the one-year forward-looking I/B/E/S earnings yield equals the 10-year nominal Treasury yield; deviations suggest over-or-under valuation.

In economics, valuation using multiples, or "relative valuation", is a process that consists of:

<span class="mw-page-title-main">Financial statement analysis</span>

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, valuation, financial health, and future prospects of an organization.

<i>Stocks for the Long Run</i> 1994 book by Jeremy Siegel

Stocks for the Long Run is a book on investing by Jeremy Siegel. Its first edition was released in 1994. Its fifth edition was released on January 7, 2014. According to Pablo Galarza of Money, "His 1994 book Stocks for the Long Run sealed the conventional wisdom that most of us should be in the stock market." James K. Glassman, a financial columnist for The Washington Post, called it one of the 10 best investment books of all time.

Earnings growth is the annual compound annual growth rate (CAGR) of earnings from investments.

<span class="mw-page-title-main">Financial ratio</span> Numerical value to determine the financial condition of a company

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

Jeremy James Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, Pennsylvania. Siegel comments extensively on the economy and financial markets. He appears regularly on networks including CNN, CNBC and NPR, and writes regular columns for Kiplinger's Personal Finance and Yahoo! Finance. Siegel's paradox is named after him.

Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Security characteristics that may be included in a factor-based approach include size, low-volatility, value, momentum, asset growth, profitability, leverage, term and carry.

References

  1. ↑ Evans, Richard (28 Jun 2014). "Super Isas are here - is it the worst time to buy?". The Telegraph. Retrieved 4 July 2014.
  2. 1 2 3 "P/E 10 Ratio". Investopedia. Retrieved 4 July 2014.
  3. ↑ "Price to 10 Year Inflation Adjusted Earnings". VectorGrader.com. Archived from the original on 13 July 2014. Retrieved 4 July 2014.
  4. ↑ Shiller, R The Mystery of Lofty Stock Market Elevations New York Times 14 Aug 2014
  5. ↑ Campbell & Shiller. "Stock Prices, Earnings and Expected Dividends" (PDF). Retrieved 23 August 2014.
  6. ↑ Johnathan Davis and Alasdair Nairn (2012). Templeton's Way With Money: Strategies and Philosophy of a Legendary Investor. Wiley, ISBN 1118149610
  7. ↑ Faber, Meb (23 August 2012). "Global Value: Building Trading Models with the 10 Year CAPE". MebFaber.com. Archived from the original on 29 July 2013. Retrieved 4 July 2014.
  8. ↑ "Shiller PE Ratio". www.multpl.com. Retrieved 23 August 2014.
  9. ↑ Siegel, Jeremy (2013-08-19). "Don't put faith in CAPE crusaders". The Financial Times.
  10. ↑ Tully, Shawn. "The data point that screams sell". Fortune. Retrieved 23 August 2014.
  11. ↑ Global Stock Market Valuation Ratios, Star Capital, Germany, June 2014
  12. ↑ Predicting Stock Market Returns Using the Shiller CAPE, Keimling, N. January 2016
  13. ↑ Robert D. Arnott, Denis B. Chaves and Tzee-man Chow. King of the Mountain: The Shiller P/E and Macroeconomic Conditions. The Journal of Portfolio Management Fall 2017, 44 (1) 55-68; DOI: https://doi.org/10.3905/jpm.2017.44.1.055
  14. ↑ Kenourgios, D., Papathanasiou, S. & Bampili, A.C. On the predictive power of CAPE or Shiller’s PE ratio: the case of the Greek stock market. Oper Res Int J (2021). https://doi.org/10.1007/s12351-021-00658-x
  15. ↑ Sébastien Lleo and William T. Ziemba. Predicting Stock Market Crashes in China. The Journal of Portfolio Management Spring 2018, 44 (5) 125-135; DOI: https://doi.org/10.3905/jpm.2018.1.078

Robert J. Shiller's data page "ONLINE DATA ROBERT SHILLER"

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.