Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn about the CAPE ratio - how it is calculated, who came up with it and how analysts use it to gauge whether the stock market is 'cheap' or 'expensive'.

What is the CAPE Ratio?

The CAPE ratio is a tool analysts use to gauge how 'cheap' or 'expensive' the stock market is. It's calculated by dividing the current market price by the 10-year average of inflation-adjusted earnings per share. That's a mouthful, so let's unpack this formula!

'Cheap' vs. 'Expensive'

If something is cheap, it means you get a lot for what you pay. If it's expensive, you get less for the same amount. For example, let's say you go the grocery store to buy a banana and you have two options - you can either buy one banana for \$1 or two bananas for \$1. There are no taste or appearance differences among the bananas. Which would you choose? The two bananas for \$1, obviously! Those bananas are cheaper because the same \$1 buys two instead of one.

The same logic applies if you invest \$1 in the stock market. Instead of receiving bananas, however, you receive your portion of the earnings the company generates. All else being equal, you want to receive more earnings for every \$1 you invest.

Earnings Yield

A useful metric to measure the amount of earnings you receive is the earnings yield. You may have seen this ratio before. The calculation is past 12-months earnings per share / current market price.

Many people consider the stock market cheap when the current earnings yield is higher than the historical average. It's considered expensive when the current earnings yield is lower than its historical average.

For example, let's say the historical earnings yield for the stock market is 7% and it is currently trading at 12%. In this case, the market would be considered cheap. A \$1 investment generates 12 cents of earnings, when historically the same \$1 investment only gave you 7 cents. Conversely, a yield of 3% would be considered expensive because your \$1 investment would only give you 3 cents.

Price-to-Earnings Ratio

The earnings yield is often translated into a common ratio many analysts use, called the price-to-earnings ratio (P/E ratio). It is simply the reverse of the earnings yield - i.e., current market price / past 12-months earnings per share.

In our examples above, an earnings yield of 12% is the same as saying the market has a current P/E ratio of 8.3, or 1 / .12. An earnings yield of 3% is the same as saying the market has a current P/E ratio of 1 / .03 = 33.3. The higher the earnings yield, the lower the P/E ratio, and vice versa.

How does all of this relate to the CAPE ratio? The CAPE ratio is just a variation of the P/E ratio.

The formula was developed by Professors Robert Shiller and John Campbell in a 1988 paper. Again, the formula is current market price / past 10-year average of inflation-adjusted earnings per share. There are two things you'll notice when you compare the CAPE ratio to a standard P/E ratio:

1. The CAPE ratio takes the average earnings in the past 10 years, instead of the past 12 months.
2. The CAPE ratio adjusts the earnings for inflation.

One drawback of the traditional P/E ratio is that it is so dependent on the past 12-months earnings that if something unexpected happened over that time period, the P/E ratio could be misleading. For example, if a plant closure reduced earnings but everyone knew this was a temporary issue, then the current market price may have stayed high while the earnings declined substantially. This would have resulted in an abnormally high P/E ratio.

To adjust for these temporary fluctuations, Shiller and Campbell smoothed the earnings out by averaging the past 10 years of earnings instead of just the past 12 months.

Shiller and Campbell adjusted for inflation as well. They changed each past year's earnings to its equivalent if the earnings had occurred today. For example, if a company produced \$1 of earnings per share last year but the inflation rate was 10%, that \$1 is the equivalent of \$1.10 today. With these two adjustments, the formula for the CAPE ratio is current market price / 10-year average of inflation-adjusted earnings per share.

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