In a fundamental analysis approach to finding sound investments, investors measure the price of a stock against some aspect of the company’s financials to determine if it constitutes good value.

One of the most common of the price-based multiples is the price-earnings (P/E) ratio, which is traditionally the current price of a stock divided by its trailing 12 months of earnings.

The price-earnings ratio embodies the market’s expectation of a company’s earnings power in the stock’s price. A high price-earnings ratio indicates that the market expects strong growth with confidence in the company’s earnings, and a low price-earnings ratio indicates that the market expects low growth or uncertainty in the company’s earnings.

However, the traditional price-earnings ratio only encompasses the past year, and one year is a short span of time to consider a company’s performance. It does not fully capture business and economic cycles, which can occur over many years depending on the industry and economy.

Benjamin Graham and David Dodd—often referred to as the originators of fundamental analysis—recommended dividing price by a multi-year average of earnings, and they suggested periods of five, seven or 10 years in their seminal book, “Security Analysis,” first published in 1934.

Following Graham and Dodd’s advice, Nobel laureate economist Robert Shiller and his former student John Campbell created the cyclically adjusted price-earnings (CAPE) ratio and studied its use starting in the late 1980s. They found that price divided by a 10-year average of earnings can be used to predict long-term performance, potentially helping investors gauge future returns for stocks.

What Is the CAPE Ratio?

There are two different ways to define the CAPE ratio. In its most basic use, the CAPE ratio is the current price of a stock divided by the 10-year rolling average of its earnings. This can be calculated for any stock with at least 10 years of earnings.

In principle, any investor could change the number of years of earnings being averaged to generate a CAPE ratio covering a different time frame, say, five years or seven years. Because the ratio’s ultimate use is in smoothing out the cyclical volatility of earnings, nothing short of five years is applicable in referring to a stock’s CAPE ratio. Graham and Dodd suggested periods of seven to 10 years as being preferable for capturing the span of a cyclical effect on a stock’s earnings.

Shiller and Campbell’s most popular iteration of the CAPE ratio uses the S&P 500 index to consider whether the market writ large is over- or underpriced. This CAPE ratio is available for free online, along with the data used to calculate it (www.econ.yale.edu/~shiller/data.htm).

The dataset for the S&P 500 goes back to 1871. This CAPE ratio is adjusted for inflation using the consumer price index (CPI) to account for real purchasing power.

The numerator used in the CAPE ratio is the current market price of the S&P 500. The denominator of the ratio is the rolling average of the preceding 10 years of S&P 500 real reported earnings.

The Illustrating Trends Dispatch in this issue of the AAII Journal shows the level of the CAPE ratio as of June 13, 2022, at 32.5.

Using the CAPE Ratio

If you calculate individual CAPE ratios for a group of comparable stocks, you could use those figures to determine the value of each stock relative to its industry peers without the interference of the volatility inherent in the basic price-earnings ratio. But what do you do as an individual investor with the CAPE ratio of the S&P 500 as determined by Shiller and Campbell?

The CAPE ratio derived from the S&P 500 shows the current long-term valuation of large-cap stocks relative to their mean (average) or median levels. The chart on Shiller’s downloadable spreadsheet visually shows how high or low the CAPE ratio is to its historical mean or median.

Shiller found that a high CAPE ratio relative to its mean or median was predictive of a too-hot market. Eventually, a high CAPE ratio indicates that the market is nearing a potential peak—though perhaps not tomorrow or next quarter—and a peak of course indicates a fall in prices of some kind.

In other words, high prices relative to 10-year average earnings suggests that prices will come down, but you don’t know exactly when. The CAPE ratio does not predict what is going to happen next year very well.

The CAPE ratio is for long-term investors. It provides insight into whether the S&P 500 is more likely to realize favorable or disappointing returns in the next five or 10 years. You may have to wait the full five- or 10-year period for the market to adjust following a period of high CAPE ratios.

For patient, long-term investors, it makes sense to use the CAPE ratio as an indicator of value, much in the same way the basic price-earnings ratio serves as an indicator of value that is immediate but short-term in perspective.

For individual investors following a prudent buy-and-hold investment strategy, the CAPE ratio of the S&P 500 is useful in setting expectations for what could occur in the market over the long term.

If the CAPE ratio of the S&P 500 is high, then investors may want to consider the valuations of other stocks (e.g., small-cap or foreign stocks) or other asset classes. They may also want to consider saving more or being more conservative with their withdrawal strategy. This is most critical for those nearing their retirement or in their retirement determining their withdrawal rates.

However, the analysis is dependent on how equities compare in valuation to those other asset classes. For much of the last decade, while the CAPE ratio has been high, interest rates were low and subsequently so were bond yields. Investors were faced with a situation where stocks may be overpriced historically but no assets offer competitive returns to move into instead. One of the inherent determinants of value investing is the level of market interest rates. A rational investor should be willing to pay a higher price for a stock, the lower the market interest rates, all else being equal.

Caveats of the CAPE Ratio

Regardless of the popularity of the S&P 500 CAPE ratio, there are criticisms to note.

One is that the ratio is currently overly bearish in sentiment. Shiller himself said in an interview with AAII Journal editor Charles Rotblut that investors should never rely on a sole measure of value of the market or a stock as a determinant of value or as a predictor of the market’s direction. Graham and Dodd expressed as much 90 years ago.

The main criticisms of the S&P 500 CAPE ratio are related to the length of time it covers. How corporate earnings are determined has changed over time. There have also been changes in what the federal government uses to calculate inflation through the CPI.

Accounting standards have changed during the period covered by the dataset used for the CAPE ratio. Standards taken for granted now—such as independent auditors certifying accounting statements, and the Financial Accounting Standards Board (FASB) codifying a single source of generally accepted accounting principles (GAAP)—were put into place over a nearly 80-year period.

In addition, treatment of research and development expenses, the granting of employee stock options and the repurchasing of shares have also led to differences between current reported earnings and reported earnings from decades ago.

Corporate tax rates have also changed over time quite considerably. Initially, after the passing of the Corporate Tax Act of 1909, the corporate marginal tax rate was 1% before rising rapidly, during World War II and the Korean War, to a peak of 52.8% in the late 1960s. Numerous exclusions, tax breaks and changes to expense periods have also been added to the tax code over the years.

Measuring inflation has also been controversial. The Federal Bureau of Labor Statistics has changed how it calculates CPI, causing it to admit that the effect of inflation was overstated for many years prior to the implementation of the changes in the 1990s.

Critics propose that the changes in accounting standards and the measurement of inflation create a situation in which the periods of time covered by the S&P 500 CAPE ratio cannot be accurately compared.

Finance professor Stephen E. Wilcox detailed these criticisms based on accounting and inflation in a September 2011 article for the AAII Journal, “A Cautionary Note About Robert Shiller’s CAPE.”

More so caveats than criticisms, it is also important to note that in its reliance on the S&P 500, the CAPE ratio is focused on domestic large-cap stocks. It may not account for the overvaluation of small caps or mid caps, which are portions of the market individual investors may benefit from due to the relative lack of focus on them. And a well-diversified portfolio could potentially include international exposure that may not be overpriced in the way the CAPE ratio implies of the U.S. market.

The CAPE Ratio Is Useful as a Measure of the Market’s Valuation

With its origin in the foundation of fundamental stock analysis and value investing, the CAPE ratio is particularly useful to investors with allocations to domestic stocks and stock-focused mutual funds and exchange-traded funds (ETFs).

Regardless of specific strategy orientation or direct involvement in portfolio asset selection, investors can keep the CAPE ratio in mind as a general marker of the value of the market. Looking at the ratio occasionally offers the opportunity to check expectations.

As Shiller indicates, the CAPE ratio does not predict when the market will turn—price movements can and do occur rapidly without notice.

But for the long-term investor, the CAPE ratio is a conservative indication of where the market stands in relation to its history, giving some indication of where we are at now and if any portfolio changes may be worthwhile to preempt the emotions of dealing with a turbulent short-term market.

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