What Is the CAPE Ratio?
The CAPE ratio, or cyclically adjusted price-to-earnings, is a powerful tool for investors seeking clarity in volatile markets. Created by Nobel laureate Robert Shiller, CAPE averages a company’s inflation-adjusted earnings over the past ten years.
This approach smooths out short-term profit spikes and recessions, offering a more reliable valuation than the standard P/E ratio, which only considers the last year’s earnings. For example, while Microsoft’s current P/E might be 36, its CAPE could soar above 60, reflecting a longer-term perspective. The higher the CAPE, the pricier the stock or index appears.
This metric is especially useful for comparing valuations across time and markets, helping investors avoid the pitfalls of short-term anomalies.
CAPE’s Strengths: Clarity, Consistency, and Context
CAPE’s main advantage lies in its ability to filter out noise from one-off events or economic downturns. By averaging a decade of earnings, it reduces the impact of sudden profit drops or windfalls, making it a more stable indicator. Investors can use CAPE to assess not just individual stocks but entire indices, like the S&P 500, providing a broad market perspective. CAPE also helps identify undervalued or overvalued markets, especially when compared across developed and emerging economies. For instance, a CAPE of 7 might signal a bargain in an emerging market but an extraordinary opportunity in a mature one. This flexibility makes CAPE a favorite among long-term investors seeking to minimize risk and maximize returns.
The Flaws of CAPE: Data Gaps and Shifting Landscapes
Despite its strengths, CAPE is not without weaknesses. It requires ten years of reliable earnings data, which can be scarce in younger markets or for newer companies. Changes in accounting standards or tax laws over a decade can distort comparisons, making historical CAPE less relevant. Sector shifts also matter: a tech-heavy market will naturally have a higher CAPE than one dominated by utilities or banks. Additionally, the way companies distribute profits has evolved, with more buybacks and fewer dividends, pushing CAPE higher than in past decades. These factors mean investors must interpret CAPE in context, considering both market structure and economic changes.
CAPE as a Guide for Smarter Investing
CAPE is a practical tool for screening investments and managing risk. Reliable CAPE data for global markets can be found on platforms like Barclays and The Idea Farm, while sector-specific values are available on sites such as GuruFocus. Comparing a company’s CAPE to its sector average helps investors avoid overpaying for growth or underestimating risk. Historical data shows that buying stocks with low CAPE ratios often leads to higher long-term returns, while high CAPE levels signal increased risk of sharp declines. For example, U.S. stocks with a CAPE above 30 have historically faced steeper drawdowns during corrections. CAPE is especially valuable for investors focused on stable, dividend-paying companies, where earnings growth is steady and predictable.
