What is CAPE ratio?

The CAPE ratio is an analytical tool that allows experts or investors to base their investing decisions on historical Index or individual company stock valuations and earning figures. It predicts future market directions, possible rate of return on Investment as well as the scope of market corrections considering the specific CAPE ratio. When applied to the NIFTY 50 index, the most recent CAPE ratio figure was 29.91, which is higher than the historical average of 15-16. This may result in a future decline in the market as it corrects itself to portray its true value.

The CAPE ratio, also known as the Shiller P/E ratio, measures the price of a stock relative to the earnings of a company per share, adjusted according to inflation. The Cyclically Adjusted Price to Earnings ratio (CAPE ratio) is generally applied to assess the value of broad equity indices. It uses real (adjusted according to inflation) Earning Per Share (EPS) over 10 years to analyse and assess long-term financial performance while also smoothing out the impact of business cycles.

How does the CAPE ratio work?

The Shiller P/E ratio has been widely used to analyse markets and warn investors when a stock is overvalued as the market is likely to correct itself over a certain period. This has also been a major advantage when a company stock is found to be undervalued or have a lower CAPE ratio as it could suggest higher returns over time.

The primary aim of the CAPE ratio is similar to that of a Price-to-Earnings (P/E) ratio as the CAPE ratio is another variation of a P/E ratio. Both ratios focus on indicating whether a stock is undervalued or overvalued and generally understanding and deciding the merit of an investment option. The aim of using the Shiller P/E ratio may determine investment merit, yet many experts are debating the use of this ratio in predicting future stocks returns with accuracy.

Criticism of CAPE ratio

Out of the multiple reasons that critics are debating against the CAPE ratio, the most common one is that the ratio is an inherently backward-looking ratio and not a forward looking one as it is based on historical evidence.

According to experts, this limits the capability of the CAPE ratio to predict future returns with accuracy as past events are observed and the market changes occurring in the near future aren’t considered.

Another debate was around the fact that the ratio is dependent on GAAP (Generally Accepted Accounting Principles) earnings, which has changed significantly since its discovery. It is believed that even if the CAPE ratio is calculated using the modified GAAPs it may still end up providing an inaccurate assessment as the outcome may be overly pessimistic. The CAPE ratio is also limited in terms of giving detailed information on market corrections.

For example, the CAPE ratio for the S&P 500 index was 30.84 in September 2020, higher than the historical average ratio of 15 - 16. Instead of a market correction to return the S&P index to its true price, over the next year an increase in this ratio was overvalued to a greater extent at 38.34 in September 2021.

How to calculate the CAPE ratio?

The CAPE ratio is applied to historical data and analytics while also keeping in mind the need to adjust according to inflation. The Earnings Per Share (EPS) are calculated as a company’s profits divided by the outstanding equity shares. This ratio takes into account 10 years to aid decision-making based on long term results. The formula for calculating this ratio is:

CAPE ratio = Price / Average earnings for 10 years adjusted according to inflation.

Conclusion

Despite its criticisms, the CAPE ratio is a valuable and integral part of measuring the sustainability of a business or index as a whole, analysing its expected market direction and/or making investment decisions. Therefore, the CAPE ratio leverages historical data spanning over 10 years and levels the impacts of economic and cyclical fluctuations.