How to use the CAPE ratio to evaluate long term stock performance

What is the CAPE ratio?

The CAPE ratio is a method of assessing long-term financial performance of a stock outside of the volatility of economic cycles. It measures a stock’s price relative to the company’s earnings per share (EPS) over a 10-year period, hence it’s nickname of P/E 10. This extended timeframe considers economic variables like recessions or rapid economic expansion.

The CAPE ratio was developed by American economist and Nobel Laureate Robert Shiller. It’s also called the Shiller PE ratio, named for its founder and structure as a twist on the price-to-earnings ratio.

In fact, the CAPE ratio is an acronym for Cyclically Adjusted Price-to-Earnings ratio. Like the P/E ratio, the CAPE is a way of judging whether a stock is under or overvalued. The ratio is most often used to assess indices and their related markets. 

CAPE ratio formula

The CAPE ratio formula is derived simply by dividing the price of a company’s stock over the average earnings of a ten-year period adjusted for inflation.

CAPE = share price / 10-year average inflation-adjusted earnings

The CAPE ratio in use

In the past, the CAPE ratio has been used to identify potential market bubbles and crashes. In 1996, Robert Shiller along with John Campbell used the CAPE ratio to show the Fed that stock prices were rising significantly faster than shareholder earnings.

With a 10-year average of inflation-adjusted earnings for the S&P 500 from 1872 to 1996, Shiller and Campbell showed the adjusted P/E ratio reached a high last seen in 1929 at the start of the Great Depression. With this data, the economists predicted the real market value of the S&P 500 would be 40% lower in ten years. They managed to foretell the 2008 market crash, when the S&P 500 fell 60% over a year and a half.

To give a modern example, let’s use the CAPE ratio to analyse Apple stock.

Apple’s current share price is about $164. The company’s 10-year average return is $3.66, adjusted for inflation. If we plug those two figures into the CAPE ratio:

$164.84 / $3.66 = 45.04

What is a good CAPE ratio?

A good CAPE ratio is not too high or too low. Preferably, a stock’s CAPE ratio sits between 10 and 15. When Shiller and Campbell presented their study to the Fed in 1996, the S&P 500 CAPE ratio was 28.

Historically, the average CAPE ratio for the S&P 500 is 17. As of April 3, 2023, the S&P 500 CAPE ratio is at 29.42. While this is higher than when Shiller and Campbell presented their findings to the Fed, economists have argued the ratio is overly pessimistic (too high) on stocks because of changes in accounting and market conditions.

High CAPE ratios, like its relative P/E ratio, can indicate attractive growth stocks or markets. The expectation of high growth means more people are willing to pay for that stock, but it also creates higher volatility and risk.

It’s important to qualify the CAPE ratio with expectations for the company or market and your own research into future performance.

Disadvantages of the CAPE ratio

The chief disadvantage of CAPE is that the ratio does not take into changes in generally accepted accounting principles (GAAP), which are constantly changing. This means changes in the calculation of earnings may distort the ratio and result in an overestimated ratio.

One solution is to use a ten-year average of a more stable earnings calculation like operating earnings or after-tax corporate profits, which often results in a lower ratio and higher forecasted returns.

Another limitation of the CAPE ratio is that it is backwards looking. Because the ratio judges future earnings based on past performance, it does not account for current market or company innovations which may raise earnings.

For these reasons the CAPE ratio is often forecasted high for positively performing companies like Apple. In that example, the share price is higher than what the CAPE ratio recommends because the company has long been a market leader.

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