Why CAPE ratio matters while tracking stock or market index's performance

If you are confused by personal finance terms, jargon and calculations, here’s a series to simplify and deconstruct these for you.

CAPE or Shiller PE ratio

The cyclically adjusted price to earnings (CAPE) ratio, also known as Shiller’s PE ratio, was derived by Robert J. Shiller, an American economist and Nobel Prize laureate in economics, in 1988.

A variant of the commonly used price to earnings ratio (PE), CAPE ratio helps gauge the performance of a stock or a market index by comparing its current price with its inflation-adjusted average earnings of the past 10 years. This helps evaluate whether the stock or market is undervalued or overvalued.


When the earnings for 10 years are considered, any fluctuations over business or market cycles are smoothened and the ratio gives a clear analysis of the long-term performance of a company or market. PE ratio, on the other hand, could be misleading since the one-time high or low profits in a business or market cycle can impact its value.

The formula used to calculate the CAPE ratio is as follows:
CAPE ratio = Current market price / 10-year average inflation-adjusted earnings

What does it indicate?

A high CAPE ratio means that the stock’s current price is higher than its earnings and, hence, it is overvalued. This can lead to lower long-term returns for investors. Similarly, a low ratio means that the stock is undervalued because its earnings are higher than its market price, and can indicate potentially high long-term returns.

Extremely high CAPE ratios have been useful in identifying economic bubbles before market crashes in the past. For instance, CAPE ratio was the highest before the Wall Street crash of 1929, Dotcom crash of the 1990s, and the 2008 financial crisis.

With the CAPE ratio currently at 39.8, a level last seen in 2000 (44) right before the Dotcom crash, it has given rise to fears of another impending market bust.

What are its limitations?

Past focus: One of the main criticisms of this ratio is that it is not forward looking as it considers the earnings of the past 10 years and does not help indicate future trends.

GAAP earnings: Since it relies on the generally accepted accounting principles (GAAP) and ignores the evolving accounting practices and tax policies, it cannot offer accurate comparisons.

Not for the short term: As the ratio considers long-term data, it can offer a good analysis only for longer horizons, not predictions for shorter periods.

Ignores share buybacks: It does not take into account any share buybacks which reduces the number of shares, increasing the earnings per share, which can distort the ratio value.