Cape Ratio

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. read more of the indices. It gives the investor an idea about whether the markets are overvalued or undervalued.

Cape Ratio Formula 

The formula for Cape Ratio is:

Cape Ratio = Share Price / 10 – Year Average Inflation – Adjusted Earnings
Cape-Ratio

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For eg:
Source: Cape Ratio (wallstreetmojo.com)

Examples of Cape Ratio

The following are examples of the Cape Ratio.

You can download this Cape Ratio Excel Template here – Cape Ratio Excel Template

Example #1

Let us take the below-mentioned example to understand the calculation of the cape ratio for an index :

Solution:

Cape Ratio Example 1

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.

Example #2

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

Solution :

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

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

It is normally preferred to predict the future pattern of the index, i.e., forecasting future returns and behavior. It also has to be noted that the method for calculating EPS has undergone changes in the last 10 years both in accounting and mathematical terms. This ratio falls into taking into account the prevailing risk-free rates by the government bonds.

Conclusion

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.

Recommended Articles

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 –

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