What is CAPE ratio?

The CAPE ratio, short for cyclically adjusted price-to-earnings ratio, is a way of judging whether a stock market looks expensive or cheap compared with the profits its companies make. It was popularised by the economist Robert Shiller, so it is also called the Shiller P/E. An ordinary price-to-earnings (P/E) ratio divides a share price by one year of earnings, meaning the profit a company makes per share. The CAPE ratio instead divides the price by the average of the past ten years of earnings, after adjusting each year for inflation, the general rise in prices that erodes the value of money over time.

Using ten years smooths out the business cycle, the recurring pattern of booms and recessions. In a boom, profits swell and a one-year P/E can make stocks look cheap. In a recession, profits shrink and the same measure can make them look very expensive. Averaging across a full cycle gives a steadier picture of what companies typically earn.

Say a hypothetical index stands at 3,000 points. Add its ten inflation-adjusted yearly earnings figures and they total $1,200. Divide by ten and the average is $120. Divide the price by that average: 3,000 ÷ 120 = 25, so the CAPE ratio is 25. If last year's earnings alone were $200, the ordinary P/E would be 3,000 ÷ 200 = 15, so the two measures can tell quite different stories. Turning the CAPE upside down gives an earnings yield: 1 ÷ 25 = 4%, meaning each $100 invested buys about $4 of average yearly earnings.

The common misunderstanding is treating a high CAPE as a sign that a fall is imminent. The ratio says little about timing, and markets can stay at high or low readings for many years. Comparisons across decades are also tricky, because accounting rules, the mix of industries in the index, the way companies return cash (more share buybacks, fewer dividends) and the level of interest rates have all changed. A reading that looked extreme in one era may reflect different conditions in another.

For a private investor, the CAPE ratio is most useful as a rough guide to expectations rather than a trading signal. A higher reading means paying more for each dollar of past earnings. Investors often use it to temper long-run return assumptions, for example when estimating a sustainable withdrawal rate in retirement or weighing how much sequence-of-returns risk a new retiree faces.

By Dr. Harry Hamann

How is the CAPE ratio calculated?
Take the market's current price, then divide it by the average of the past ten years of earnings, with each year's earnings adjusted for inflation into today's money. The result shows how many dollars investors pay for each dollar of typical, cycle-smoothed earnings.

What is a good CAPE ratio?
There is no single good level. A lower reading means a market is cheaper relative to its earnings history, and a higher one means it is pricier. Comparisons work best within the same market, while allowing for changes in accounting, industry mix and interest rates.

Can the CAPE ratio time the market?
Not reliably. High or low readings can persist for many years, so the ratio gives little indication of when prices might rise or fall. It is used more for setting long-run expectations than for deciding when to buy or sell.

Who created the CAPE ratio?
It is associated with the economist Robert Shiller, which is why it is often called the Shiller P/E. It builds on the long-standing idea of judging stocks by their average earnings over several years rather than a single year.