CAPE Ratio
It is a measure that uses the price-to-earnings ratio to evaluate a company's long-term financial performance while minimizing the economic cycle's impact.
What is the CAPE Ratio?
CAPE is a measure that uses the price-to-earnings ratio to evaluate a company's long-term financial performance while minimizing the economic cycle's impact. It is also known as Shiller P/E, which is often used to assess the S&P 500 stock market in the US.
It is mainly used to predict future stock returns over the next 10 to 20 years, smoothing out fluctuations and the business cycle's impact on a company's profit. Using this ratio is vital, as it helps to give a better image of a company's long-term profitability.
It is used on broad stock market indices to determine whether the market is undervalued or overvalued. This ratio is used to determine if a stock is undervalued or overvalued by comparing its current market price to its historical earnings record after adjusting for inflation.
Generally, relying on one-year earnings doesn't accurately predict long-term company financial performance. As a result, John Y. Campbell and Robert Shiller stated that future earnings could be expected using a long-term moving average of actual profits.
In other words, predicting future earnings cannot be accurate unless average earnings for five to ten years are considered and the results are adjusted for inflation. However, the earnings volatility rate is low during a more extended period as it smoothes out the fluctuations and business cycle consequences on the company's earnings.
This ratio has an inverse relationship with earnings on equity:
- Higher ratio values mean lower than average annual returns over the long term. As a result, investors expect a lower return for the following 10-20 years.
- Lower ratio values mean higher than average annual returns over the long term. As a result, investors expect a higher return for the next 10-20 years.
Investors can rely on this ratio before purchasing a company's stock as it can help them compare companies in the same industry. Investors often pick companies with low cape ratios, indicating high long-term returns.
Key Takeaways
- Cape is a way to evaluate a company's long-term financial performance by using the price-to-earnings ratio and smoothing out the effects of the business cycle on performance.
- Forecasting a company's future earnings can't be accurate without considering the average earnings of the last five to ten years and adjusting for inflation.
- This ratio and earnings have an inverse relationship:
- A high ratio means the company's stock price is significantly higher than it should be, based on its earnings. This ratio means it's overpriced. Generally, the firm's stock price would drop to reflect the stock's actual value.
- A low ratio means the company's stock price is significantly lower than it should be, based on its earnings. This ratio means it's undervalued. Generally, the market would increase the firm's stock price to reflect the stock's actual value.
- This ratio is calculated by dividing the share price by average earnings for ten years adjusted for inflation.
- Some of its benefits include the following:
- It helps financial analysts and investors evaluate stock prices.
- It takes into account critical metrics that have a potential impact on the stock's market value.
- It helps financial analysts and investors change their investment strategies as the market conditions change.
- Some of its disadvantages are:
- Due to changing accounting methods, no guarantee will be given to maintain 100% accuracy.
- Comparing competitors in the same industry using this ratio is difficult due to factors including changing market conditions.
- This ratio ignores key metrics, including dividend yield and the risk-free rate, that strongly impact the market value.
The Formula for the CAPE Ratio
This ratio is a tool that helps to evaluate a company's earnings over 10 to 20 years, flattening fluctuations and minimizing the business cycle's consequences.
This ratio is calculated by dividing the share price by average earnings for ten years adjusted for inflation.
CAPE Ratio = Share price / Average earnings for ten years, adjusted for inflation.
Where,
- Share price: The share price is the current market value of the company's stock. When publicly-traded company shares are issued, the market price reflects the company's value. The market sets share prices based on factors in or outside the company, such as earnings, life cycles, political changes, and economic conditions.
- Average earnings, adjusted for inflation: Average earnings are the number of money firms in a particular industry, region, or economy earn over time. Earnings adjusted for inflation measure a company's profits for a specific period. After removing inflation and the other economic forces' impact on earnings.
Interpreting CAPE Ratio
This ratio can be categorized into a couple of scenarios:
1. A firm with an extraordinarily high ratio
This value indicates that the company's stock price is significantly higher than what would be reasonable for the company's earnings and is, hence, overpriced.
Therefore, the firm's stock price is usually ultimately adjusted (dropped) by the market to reflect the company's actual value.
2. A firm with an extraordinarily low ratio
This value indicates that the company's stock price is significantly lower than what would be reasonable for the company's earnings and is, hence, undervalued.
Therefore, the firm's stock price is usually ultimately adjusted (increased) by the market to reflect the company's actual value.
Example of the CAPE Ratio
Let's take a few examples to understand the concept better.
Let's take example 1:
TYL company has the following information:
- Current market value = 2,000
- Current P/E ratio = 18
- Current EPS = 200
- Inflation-adjusted EPS for ten years = 100
Calculate the company's cape.
Cape ratio = Share price / Average earnings-10 years, adjusted for inflation.
CAPE Ratio = 2,000 / 100 = 20
The ratio is higher than the current P/E ratio of 18. This value states that the company's stock price is higher than what would be shown by the company's earnings and is overvalued. As a result, the market would adjust and lower the company's stock price to reflect its actual value.
When a company has a lower ratio, investors might consider purchasing the stock as its value will increase in the long term.
Another example:
LYC company has the following information:
- Current market value = 6,000
- Current P/E ratio = 25
- Current EPS = 500
- Inflation-adjusted EPS for 10 years = 400
Calculate the company's cape.
CAPE Ratio = Share price / Average earnings-10 years, adjusted for inflation.
CAPE Ratio = 6,000 / 400 = 15
The company's ratio is 15, while the P/E ratio is 25. The ratio is much lower than the current P/E ratio. This value indicates that the company's stock price is undervalued and does not reflect its earnings.
As a result, the market would adjust and increase the company's stock price to reflect its value.
Considering the previous examples, which company should someone select if they want to invest?
Investors should invest in LYC company as its cape ratio is lower than its P/E ratio, which usually increases its value in the market.
CAPE Ratio Advantages
Investors interested in getting knowledge of the long-term company financial performance could find that the cape ratio is a better metric to answer their questions. Using this ratio has advantages and disadvantages.
Some advantages of using this ratio include the following:
1. It helps financial analysts and investors
This ratio helps investors to decide whether to buy or sell stock and, hence, change their investment strategies accordingly.
2. It helps evaluate stock prices.
This ratio helps evaluate whether the stock price has been overvalued or undervalued for an extended period. Keep in mind that the stock price is undervalued if the cape ratio is higher than the P/E ratio. In contrast, overvaluation is indicated by the P/E ratio being more significant than the cape ratio.
3. It takes into account critical metrics in the stock market, including:
- Company earnings per share: The EPS is a widely used indicator for determining a company's value because it shows how much money a firm produces for each share of its stock. Increasing EPS leads to an increase in the market value of the stock price.
- Inflation rate : When it comes to investing, having a solid understanding of inflation is necessary because it can potentially lower the value of investment returns. All areas of the economy, including consumer spending, company investment, government programs, tax laws, and interest rates, are susceptible to the effects of inflation.
CAPE Ratio Disadvantages
Some disadvantages of this ratio include the following:
1. Less practical process
It is a more mathematical process requiring calculating the average adjusted inflation earnings. In addition, these earnings can sometimes be less practical and complicated as the inflation rate changes continuously.
2. No guarantee to give 100% accuracy
Developing the ratio evolves the accounting methods. Unfortunately, this makes accurate historical comparisons more challenging because profits aren't continuously computed similarly.
That is why there is no guarantee that the metric will always provide correct results.
3. Comparison difficulties
Comparing competitors in the same industry using this ratio is challenging due to changes in market conditions, government regulations, and people's preferences.
Even if a financial analyst can find ample information from the past ten years to compare two companies, they can't get an accurate image of which company would perform better financially in the future.
4. It ignores critical metrics, including the following:
a. Market trends
Market demand changes fast; what was trending in the last five years becomes old-fashioned nowadays, and what is on fire today might disappear next year.
This ratio doesn't consider market changes in demand and supply that significantly impact the company's value.
People's preferences and tastes fluctuate, impacting the company's stock value. So, ignoring people's choices and trends could decrease the accuracy of forecasts of the company's financial performance.
b. Risk free-rate
The risk-free rate is the minimum return an investor anticipates receiving from any investment. Investors will not take on additional risk unless the possible rate of return is higher than the risk-free rate.
The risk-free rate could impact the company's value, so investors must consider this metric to get a better image of the company's financial performance in the long term.
c. Dividends yield
The dividend yield formula figures out how much a company pays in dividends each year compared to its market value. It tells you how much dividend payments shareholders will receive in the future, based on the market value of that share.
Market value and yield are inversely related. Assuming the dividend rate stays the same, an increase in the market value of the shares causes the dividend yield to decrease, whereas a decrease in the stock's market value causes the dividend yield to rise.
Due to yield's impact on market value, investors should consider this metric; otherwise, they may get an inaccurate image of the company's performance in the short- or long-term.
d. Regulations and laws
The government continuously updates market laws and regulations based on economic forces. In addition, some world crises force the government to devise rules to maintain business activities, minimizing the negative impact on the environment and society.
Suppose a company, TYL, produces a popular product, increasing its market share in the industry. However, the government noticed that TYL's manufacturing activities pollute the environment, impacting the health of nearby citizens.
To stop the company's activities, the government sets new regulations ranging from boosting environmental quality assurance to protecting the customers.
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