Cyclically-Adjusted Price-to-Earnings Ratio (CAPE Ratio)

• The Bottom Line: The CAPE ratio is a powerful valuation tool that provides a stable, long-term view of the market by averaging a decade of inflation-adjusted earnings, helping you avoid overpaying during temporary market highs or panicking during lows.
• Key Takeaways:
• What it is: A modified P/E ratio that uses the average of the last 10 years of real (inflation-adjusted) earnings in the denominator instead of just one year's earnings.
• Why it matters: It smooths out the peaks and troughs of the economic business_cycle, offering a more reliable picture of a market's or company's true long-term earning power, which is essential for establishing a margin_of_safety.
• How to use it: Use it as a valuation “thermometer” to gauge whether the overall stock market (or a cyclical company) is historically cheap or expensive, guiding your long-term investment decisions.

Imagine you're a scout for a baseball team, and you need to assess a new slugger. You could just look at his performance from last season. If he hit 50 home runs, you might offer him a massive contract. If he only hit 10, you might pass. The standard Price-to-Earnings (P/E) ratio is a bit like that scout looking at only one season. It takes the current stock price and divides it by the company's earnings from the most recent 12 months. It's a useful snapshot, but it can be misleading. What if last year was a fluke? A career-best season fueled by luck, or a terrible season marred by a single, temporary injury? The Cyclically-Adjusted Price-to-Earnings (CAPE) ratio, also known as the Shiller P/E, is like the wise, veteran scout who insists on watching the game tapes from the player's entire last decade. Developed by Nobel laureate economist Robert Shiller, the CAPE ratio takes a much longer view. Instead of using just one year of earnings, it averages the last ten years of a company's or market's earnings, and it adjusts each of those years for inflation. This 10-year average gives you a much more stable, reliable, and representative picture of the slugger's true, sustainable hitting power. It smooths out the single great season and the single terrible season, revealing the underlying reality. In essence, the CAPE ratio asks a simple but profound question: “How much are we paying today for a company's average, inflation-adjusted earnings power over a full business cycle?”

“The investor's chief problem—and even his worst enemy—is likely to be himself.” - Benjamin Graham ¹⁾

By looking at a full decade, the CAPE ratio helps investors see through the short-term noise. When the economy is booming and profits are artificially high, the standard P/E can make stocks look deceptively cheap. The CAPE ratio, with its memory of more normal (and even lean) years, will likely remain elevated, flashing a warning sign. Conversely, in the depths of a recession when profits temporarily vanish, the standard P/E can become meaninglessly high or even negative. The CAPE ratio, remembering the profitable years, provides a more sober assessment of value and can highlight incredible buying opportunities.

For a value investor, the CAPE ratio isn't just another financial metric; it's a philosophical tool that aligns perfectly with the core tenets of the discipline. It's a quantitative embodiment of the patience, discipline, and long-term perspective that separate investing from speculation.

• It Champions a Long-Term Perspective: Value investing is about owning a piece of a business for years, not renting a stock for minutes. The CAPE ratio's 10-year window forces this perspective. It discourages you from getting swept up in the latest quarterly earnings report or “story” and instead anchors your analysis in a decade of actual performance. It helps you think like a business owner, not a gambler.
• It Helps Estimate Normalized Earnings Power: A central task for any value investor is to estimate a company's intrinsic_value. To do this, you need a realistic idea of its average earnings over time, or what Benjamin Graham called “normalized earnings power.” A single year is often not normal. The 10-year average provided by CAPE is one of the best and simplest ways to approximate this crucial figure, especially for the market as a whole or for companies in cyclical industries like manufacturing, energy, or construction.
• It Is a Powerful Tool for Defining a Margin of Safety: The single most important rule of value investing is to buy with a margin of safety—paying a price significantly below a business's intrinsic value. The CAPE ratio helps you identify when this margin is available. When the market-wide CAPE is at a historical low (e.g., in 1982 or 2009), it's a strong signal that fear has driven prices well below long-term earning power. This is when the largest margins of safety are typically found. Conversely, when the CAPE is at an all-time high (e.g., in 1999), it signals that euphoria has erased any margin of safety, and risk is extremely high.
• It Promotes Contrarian Thinking: Warren Buffett famously advises investors to be “fearful when others are greedy, and greedy when others are fearful.” The CAPE ratio gives you the data to do this with confidence. When the news is great and the standard P/E looks reasonable, a high CAPE reminds you that you're paying a premium relative to history. It gives you the courage to be cautious. In a market crash, when fear is rampant and standard P/Es are useless, a low CAPE can give you the analytical backbone to buy when everyone else is selling.

While the concept is intuitive, the calculation has a few specific steps. Let's break it down. The formula is: CAPE Ratio = Current Market Price / (10-Year Average of Inflation-Adjusted Earnings) Here is the step-by-step method:

1. Step 1: Gather the Data: Collect the as-reported earnings per share (EPS) for a market index (like the S&P 500) or a specific company for each of the past 10 years.
2. Step 2: Adjust for Inflation: Take each of those 10 annual EPS figures and adjust them to today's dollars using an inflation index like the Consumer Price Index (CPI). This is a crucial step. It ensures you're comparing apples to apples, as a dollar of earnings in 2014 was worth more than a dollar of earnings today.
3. Step 3: Calculate the Average: Add up the 10 inflation-adjusted EPS figures from Step 2 and divide by 10. This gives you the “E10”—the 10-year average of real earnings.
4. Step 4: Divide Price by Average Earnings: Take the current price of the index or stock and divide it by the E10 figure you calculated in Step 3. The result is the CAPE ratio.

Luckily, you don't have to do this math yourself. Many financial websites provide the current and historical CAPE ratio for major market indices. Robert Shiller's own website is the primary source for this data.

A CAPE ratio number in isolation is meaningless. The key is context. You must compare the current CAPE ratio to its own long-term historical average. For the U.S. stock market (S&P 500), the long-term historical average since the late 1800s is around 17.

• A High CAPE Ratio (e.g., over 25): This suggests that the market is expensive relative to its historical earning power. It implies that investors are paying a high price for each dollar of normalized earnings. This doesn't mean a crash is imminent, but historical data shows that starting valuations this high are often followed by a decade of low or even negative real returns. It's a signal for caution and a reminder that your margin of safety is thin.
• A Low CAPE Ratio (e.g., under 15): This suggests that the market is cheap relative to its history. Investors are pessimistic and paying a low price for each dollar of normalized earnings. Again, this doesn't mean the market will rocket up tomorrow, but it indicates that the odds are in your favor. Historically, periods of low CAPE ratios have been followed by periods of high long-term returns. This is where value investors find fertile hunting grounds.

The Ultimate Trap: The CAPE ratio is a terrible tool for timing the market. It is a valuation indicator, not a predictive one. The market can remain at a high CAPE for many years before it corrects (as it did in the late 1990s), and it can stay at a low CAPE for a frustratingly long time before it recovers. Its best use is not to tell you when to buy or sell, but to inform you about the level of risk and potential future return embedded in the market at any given time.

Let's see how the CAPE ratio prevents an investor from making a classic mistake: getting fooled by peak earnings in a cyclical industry. Consider two fictional companies, both currently trading at $150 per share.

Looking only at the standard P/E ratio, “Flashy Construction” looks like a bargain! It's twice as cheap as the boring food company. A novice investor might pile in, thinking they've found a great deal. Now, let's bring in the veteran scout—the CAPE ratio. We look back at 10 years of inflation-adjusted earnings.

• Flashy Construction Inc.: The construction business is a roller coaster. During boom years, earnings were high ($15, $12), but during the last recession, they had losses (-$5) and several years of meager profits ($1, $2). The 10-year average real EPS comes out to just $6.
• Steady Edibles Co.: People buy snacks in good times and bad. Their earnings are incredibly consistent, hovering around $7.50 every year. The 10-year average real EPS is, unsurprisingly, $7.50.

Let's recalculate the valuation with CAPE:

The story has completely flipped. The CAPE ratio reveals that “Flashy Construction” is actually the more expensive stock. Its current cheap-looking P/E was an illusion created by a single, unsustainable boom year. “Steady Edibles,” while never looking statistically cheap, is priced more reasonably relative to its reliable, long-term earning power. A value investor, guided by the CAPE ratio, would avoid overpaying for the cyclical company at the top of its cycle and correctly identify the higher-quality, more fairly priced business.

• Smooths Business Cycle Volatility: Its greatest strength is its ability to filter out the short-term noise of economic booms and busts, giving a clearer signal of underlying valuation.
• Encourages Long-Term Thinking: It structurally forces an investor to adopt a decade-long viewpoint, which aligns perfectly with the value investing philosophy.
• Strong Historical Track Record: There is a powerful and well-documented historical correlation between the starting CAPE ratio and subsequent 10-year market returns. Low CAPEs have generally led to high returns, and high CAPEs to low returns. ²⁾.

• It is NOT a Market Timing Tool: This cannot be stressed enough. High valuations can persist for years, and low valuations can get even lower. Using CAPE to predict the exact top or bottom of the market is a recipe for frustration and failure.
• Accounting Rule Changes: The way companies report “earnings” has changed over the last century. Critics argue that modern accounting standards are more conservative than in the past, potentially making today's CAPE ratio appear artificially higher than historical figures.
• Ignores Interest Rates: Valuation doesn't happen in a vacuum. The prevailing level of interest rates has a major impact on what constitutes a “fair” price for stocks. The CAPE ratio, by itself, does not account for this. A CAPE of 25 might be dangerously high when interest rates are 5%, but more justifiable when they are 1%.
• Changing Economic Structure: The composition of the stock market has changed dramatically. In the past, it was dominated by capital-intensive industrial and manufacturing companies. Today, it is more heavily weighted towards asset-light technology and service companies with higher profit margins. This structural shift could mean that the long-term average CAPE ratio should now be higher than it was in the past.

• price_to_earnings_ratio_pe
• margin_of_safety
• intrinsic_value
• mean_reversion
• business_cycle
• normalized_earnings_power
• behavioral_finance