Cyclically adjusted p/e ratio (Cape)

A classic price/earnings ratio is the relationship between the current share price and one year's earnings, usually the last year, or a forecast for the year ahead...

The price/earnings (p/e) ratio is a popular measure for assessing whether a share is cheap. It’s simple to calculate – you just divide the share price by earnings per share. A low number (eg, below ten) suggests that you aren’t paying much for each £1 of earnings, while a high number indicates a stock may be expensive (unless it’s growing rapidly).

A 1988 paper by John Young Campbell of Princeton and Robert Shiller of Yale University concluded that the level of the Cape ratio was strongly negatively correlated with long-term returns: when it is high, future returns are lower. (The ratio is also known as the Shiller p/e due to Shiller’s role in popularising it.) The Cape ratio later indicated that the US market was very expensive ahead of the dotcom bust in 2000, which helped it gain a name for itself, even though Shiller did point out that it is not a short-term forecasting tool.

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It also signalled more weakly that stocks had become cheap during the 2008-2009 crisis (but did not fall as low as it had in past crises). This suggests that care is needed when comparing a Cape ratio with its long-term history – in part because accounting standards and the composition of an index change over time.

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