P/E 10 Ratio

Core Description

• The P/E 10 Ratio, also known as CAPE or Shiller P/E, smooths business cycle effects by dividing current market price by the average of inflation-adjusted earnings over the past ten years.
• It offers a long-term valuation perspective for broad equity indices, reducing short-term noise compared to single-year P/E metrics.
• The P/E 10 Ratio is mostly used for strategic allocation and risk assessment, not for market timing or individual stock selection.

Definition and Background

The P/E 10 Ratio, commonly referred to as the CAPE (Cyclically Adjusted Price-to-Earnings) ratio or Shiller P/E, is a valuation metric designed to provide a normalized, long-horizon measure of equity market valuation. Developed from the ideas of Benjamin Graham and David Dodd, and formalized by economists John Campbell and Robert Shiller in the 1990s, the P/E 10 divides the current price (or index level) by the average of inflation-adjusted earnings per share (EPS) from the past ten years. This decade-long averaging smooths out the swings of the economic cycle, offering investors a view that is less affected by recent booms or recessions.

CAPE gained recognition following the technology bubble of the late 1990s and the financial crisis in 2008, highlighting periods of significant market overvaluation and muted longer-term returns. Academic research indicates that, historically, higher CAPE values have typically preceded lower long-term real returns, while low CAPEs have been linked with stronger subsequent performance. However, these relationships are not exact and may be influenced by broader economic regimes.

CAPE is particularly suited for broad equity indices with long, reliable datasets, such as the S&P 500. It is not designed to evaluate individual stocks because of shorter business cycles, company-specific events, and less stable earnings histories at the single-company level.

Calculation Methods and Applications

Calculation Steps

1. Data Collection: Obtain at least 10 years (ideally monthly) of historical EPS data for the relevant index or market.
2. Inflation Adjustment: Convert each past month’s or year’s EPS to current dollar terms by adjusting for inflation, typically with a consumer price index (CPI).
3. Averaging: Calculate the arithmetic mean of these inflation-adjusted (real) EPS figures over the previous ten years.
4. Ratio Computation: Divide today’s index level by the ten-year average real EPS to calculate the CAPE.

Formula:CAPE(t) = Price(t) / Average Real EPS (last 10 years),
where Average Real EPS = (1/120) × SUM [EPS_t-i × (CPI_t / CPI_t-i)] for all months i in the past ten years.

Applications

• Strategic Asset Allocation: Institutional investors and pension funds use CAPE to adjust equity allocations over multi-year periods, tilting towards relatively undervalued or away from overvalued markets based on historical levels.
• Return Assumptions: CAPE serves as one input when estimating expected long-term returns for investment portfolios. For example, the S&P 500’s CAPE above 40 during the year 2000 was followed by a period of lower real returns over the next decade.
• Risk Management: Risk professionals use CAPE to stress-test portfolios, particularly when starting valuations are elevated.
• Macro Strategy: CAPE operates alongside signals like bond yields and credit spreads to inform macroeconomic regime analysis and investment planning.

Comparison, Advantages, and Common Misconceptions

Key Comparisons

• Trailing P/E: Uses earnings from the past 12 months, so it shifts noticeably during recessions or recoveries. CAPE reduces these swings by averaging over a longer timeline.
• Forward P/E: Uses earnings forecasts for the next year. While more forward-looking, it depends on analyst estimates which can be optimistic or imprecise. CAPE relies on realized, inflation-adjusted earnings.
• PEG Ratio: Divides P/E by projected earnings growth. While suitable for high-growth stocks, it is highly sensitive to estimation accuracy and is less relevant for index-level analysis like CAPE.
• Price-to-Book (P/B): Relates price to net asset value. It is more relevant to capital-heavy industries but less informative in economies focused on intangible or light-asset sectors.
• EV/EBITDA: Considers capital structure and depreciation policies, but still reflects short-term business conditions. CAPE, by covering a longer window, offers more robust market-level context.
• Price-to-Sales (P/S): Helpful when earnings are temporarily depressed, but it ignores profit margins.
• Dividend Yield: Highlights cash payouts but does not reflect retained earnings or buybacks.
• Earnings Yield: The inverse of CAPE, useful for comparing equity returns to fixed income alternatives.

Advantages

• Noise Reduction: CAPE’s multi-year averaging dampens unsustainable swings in earnings due to economic cycles or accounting changes.
• Long-Term Relevance: Historical data show a stronger relationship between CAPE and 7–10 year forward returns compared to the one-year P/E ratio.
• Broad Insight: Supports disciplined rebalancing and helps maintain an objective perspective during market extremes.

Disadvantages

• Lagging Indicator: CAPE is slower to respond after recessions or structural changes in profitability, taxes, or accounting rules.
• Backward-Looking: Includes information from years that may be less relevant if the market or economy has fundamentally changed.
• Cross-Market Limits: Different accounting standards, economic sectors, dividend policies, and inflation rates can complicate cross-country CAPE comparisons.

Common Misconceptions

• Market Timing: CAPE is not a tool for predicting imminent market peaks or troughs. Using it for timing can result in missed opportunities during extended market rallies.
• Single Stock Use: CAPE does not work well for assessing individual stocks due to company-specific dynamics and limited earnings history.
• Fixed Thresholds: Relying on strict cutoffs (e.g., CAPE above 25 means “expensive”) is misleading, because economic context and historical norms shift over time.

Practical Guide

Using the P/E 10 Ratio effectively requires a consistent and reproducible approach. The following outlines the general process:

1. Gather and Clean the Data

Obtain at least 10 years of historical EPS data for the relevant index. For the S&P 500, this can be sourced from S&P Dow Jones Indices or academic databases such as those maintained by Robert Shiller. Ensure EPS figures are consistent (preferably GAAP earnings) and exclude known restatement bias where feasible.

2. Adjust for Inflation

Use a reputable CPI series to convert each historical EPS entry into current dollar terms. For example, to value as of December 2023, multiply each year’s EPS by (CPI_Dec2023 / CPI_PastYear).

3. Compute the Average

Find the arithmetic mean of all inflation-adjusted EPS numbers over the target 10-year period.

4. Compute the CAPE Ratio

Divide the current index level by the 10-year average real (inflation-adjusted) EPS.

Table: Example Calculation (Hypothetical, Not Investment Advice)

5. Interpret in Historical Context

Review the calculated CAPE relative to the index’s historical percentiles, not as an absolute figure. For example, a CAPE of 20 might be historically high in one region but average in another.

Case Study

For the S&P 500, at the high point of the dot-com bubble in early 2000, the CAPE reached around 44. Data indicate that investments begun at such levels saw below-average real returns over the subsequent decade. By contrast, when the CAPE was close to 7 in the early 1980s, the following 10-year returns exceeded long-term averages.

Key Lessons:

• CAPE extremes do not provide precise entry or exit points but are correlated with long-term risk and return patterns.
• Extended bull markets can persist even if CAPE indicates expensive conditions, as observed between 1996 and 2000.

Resources for Learning and Improvement

• Foundational Papers:
  • Campbell, J. Y., & Shiller, R. J. (1988 & 1998): Studies on valuation ratios and long-run returns.
  • Shiller, R. J. (1981): Analysis of market volatility and earnings.
• Books:
  • Irrational Exuberance by Robert Shiller.
  • Stocks for the Long Run by Jeremy Siegel.
  • Expected Returns by Antti Ilmanen.
  • Damodaran on Valuation by Aswath Damodaran.
• Data Sources:
  • Robert Shiller’s CAPE database (online)
  • S&P Dow Jones Indices
  • Bureau of Labor Statistics (CPI data)
  • MSCI and Global Financial Data for international indices
• Methodology Guides:
  • S&P index methodology documentation
  • Whitepapers from Research Affiliates and GMO
  • Peer-reviewed articles on CAPE applications and limitations
• Dashboards and Tools:
  • Multpl.com: Historical S&P 500 CAPE tracking
  • FRED (Federal Reserve Economic Data): Macroeconomic statistics
  • Public academic GitHub repositories: For CAPE calculation code and templates
• Professional and Practitioner Commentary:
  • AQR Capital’s “CAPE Fear?” analysis
  • GMO letters and outlooks
  • Industry blogs such as Philosophical Economics and CFA Institute research insights

FAQs

What is the P/E 10 (CAPE) Ratio and why is it useful?

The P/E 10 (CAPE) Ratio divides the current market price by the average of inflation-adjusted earnings over the past ten years. This approach smooths profits across market cycles and provides a more consistent representation of long-term valuation.

How is the P/E 10 Ratio calculated?

It requires at least ten years of earnings per share (EPS) data, each entry adjusted for inflation. The average of these real EPS values is then used as the denominator, with the current index price serving as the numerator.

How does the P/E 10 compare to the trailing or forward P/E?

The P/E 10 reduces short-term volatility and cyclical trends, while the trailing P/E uses the most recent 12 months of earnings—making it sensitive to sudden events. The forward P/E is based on analyst projections and may not always reflect realized performance.

Does a high or low P/E 10 guarantee market performance?

No. Although a high CAPE has historically indicated lower long-term returns, and a low CAPE higher returns, other factors such as interest rates and economic shifts also influence outcomes. Relationships are not deterministic.

Can the P/E 10 Ratio be used for single stocks?

Generally, no. Most companies do not have stable, extended earnings histories and may be affected by special events such as mergers or structural changes. CAPE is designed for indices.

What are some main limitations of CAPE?

CAPE reflects past earnings, so it is not fully responsive to changes in market structure, sector composition, payout policy, or accounting rules. It is not suitable for short-term timing.

Is the P/E 10 Ratio comparable across markets and countries?

Direct comparisons can be misleading due to differences in accounting standards, sector weights, tax regulations, and inflation. CAPE should be compared to its own historical distribution within each market.

Has CAPE accurately predicted market crashes or bull runs?

While high CAPE values often came before periods of lower long-term returns, many robust market increases have taken place even when CAPE was elevated. CAPE is intended as a context tool rather than a precise timing indicator.

How does inflation and its measurement affect the CAPE calculation?

CAPE uses inflation-adjusted earnings, so the reliability and consistency of the CPI or selected inflation index is crucial. Inconsistent adjustments risk misrepresenting valuations.

Conclusion

The P/E 10 Ratio (CAPE) is a widely recognized tool for evaluating the long-term valuation of equity markets. Averaging real earnings over a decade helps buffer the effects of short-term volatility and cyclical swings, supplying investors and asset allocators with a grounded, long-term context for market expensiveness. While valuable for setting expectations and informing strategic allocation, CAPE is not a predictive tool for short-term moves. Its interpretation should take into account evolving economic structures, changing accounting norms, and market composition. When used alongside other valuation metrics and sound risk management, the P/E 10 Ratio can help anchor long-term perspectives and foster consistent decision-making, particularly in emotionally charged markets. As with all metrics, its greatest benefit comes from prudent analysis, historical perspective, and integration within a comprehensive investment process.