What is Cape Ratio?
Cape Ratio, usually applied to the indices, is a PE valuation multiple calculated by using earnings per share that is adjusted for cyclical changes in economy and inflation. It was invented by Mr. Robert Shiller, a professor from Yale University in the united states, to analyze the impact of the economic situation on the PE RatioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. of the indices. It gives the investor an idea about whether the markets are overvalued or undervalued.
- It is commonly used by a financial and stock market analyst to decide on their investment strategiesInvestment StrategiesInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on., i.e., whether to buy or sell the stocks in the market.
- It is usually used to predict the future return from the stock or the index in the next 10 to 20 years by using the historical 10 years data and adjusting the same with the inflation factor to arrive at the most correct earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. number.
- It takes into account the economic changes that have a huge impact on businesses that are more cyclical in nature.
Cape Ratio Formula
The formula for Cape Ratio is:
Examples of Cape Ratio
The following are examples of the Cape Ratio.
Let us take the below-mentioned example to understand the calculation of the cape ratio for an index :
In the above example, the Past 10 yrs EPS data has been plotted in an excel sheet, and adjusted EPS has been worked ours by removing the inflation factor from each year EPS to arrive at the correct comparable EPS. post which the same is average out for a period of 10 years to arrive at the average 10 year inflation-adjusted EPS.
Cape Ratio = 1000/52.13 = 19.12. This signifies that although the current pe ratio is 10, the cape ratio is 19.12 i.e., the index is overvalued.
Let us take another, e.g., to understand this concept better. Below mentioned are the details for the s&p 500.
- PE Ratio = 16
- Cape Ratio = 32
- Historical Avg PE Ratio = 17
In the above case, although the historical pe ratio based upon the simple averages is similar to the current pe ratio, still the index is very much overvalued, taking into account the cape ratio, which takes the inflation-adjusted pe ratio for the past 10 yrs thus giving a better picture on the pe ratio of the index and allowing investors to make an informed decision.
It will be better for the investors not to put their money in the current high priced market as reflected by the cape ratio and stay put till there is a correction, and the cape ratio declines a bit and comes to the normally expected pe ratio for the markets.
You can refer to the above given excel template for the detailed calculation of the cape ratio.
Advantages of Cape Ratio
It is one of the most important tools to analyze the pe ratio of the index, taking into consideration the cyclical changes in the economy over a period of time. Below mentioned are some of the major advantages of the cape ratio :
- It is very easy to calculate in an excel sheet.
- It factors inflation in the economy over a period of time.
- It gives a fair picture and value of the pe ratio since the past 10 years average is taken after adjusting the same with the inflation factor to arrive at the correct avg EPS.
- A good parameter to observe the future pattern of the index;
Disadvantages of Cape Ratio
- Businesses cannot be compared with the way they operated 10 years ago, and in the manner they operate today.
- Massive changes in regulatory and accounting laws have taken place over a decade.
- The reason for the higher pe ratio currently is due to the rise in the interest rates by the federal bank.
- It completely ignores the dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock..
- It does not take into account the increase in the demand for investment in stock markets as it was 10 years ago.
- It does not take into account all the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. investments in the market like the sovereign yield bonds, fixed deposits, etc.
Limitations of Cape Ratio
- More mathematical less practical.
- It ignores the demand-supply function, which is the basics of economics.
- Preferences and investment patterns of the people change over a period of time.
- More complicated.
Points to Note
Cape Ratio is a mechanism to gauge whether a particular stock or index is overvalued or undervalued. It helps to smoothen the impact of the cyclical changes and the economic changes and gives a better picture of the calculated EPS to forecast the future returns of the same. A higher cape ratio is certainly not an indicator of the market crash. It only gives a trigger point to the investor to be cautious as it’s a reflection of the trend in the economy.
This article has been a guide to what is Cape Ratio and its definition. Here we discuss its formula to calculate Cape Ratio for an index along with examples, advantages, and disadvantages. You can learn more about valuation from the following articles –