Glossary

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...

Investors often use the price/earnings (p/e) ratio to judge whether a stock is cheap or not. It's a simple measure to calculate (hence its popularity) you simply divide the share price by earnings per share. A low number (below ten, say) suggests that you aren't paying much for each given £1 of earnings, while a high number indicates a stock may be expensive (or growing rapidly).

However, the basic p/e is highly flawed. Using just one year of profits means a stock particularly one in a cyclical business, such as mining can look cheap because profits happen to be peaking at that point, and are set to plunge when business turns back down in line with the economic cycle.

So in the 1930s, value investors Benjamin Graham and David Dodd suggested that analysts should instead take the average of earnings for the previous five to ten years. This smooths out the data, minimising the impact of economic cycles.

John Young Campbell of Princeton and Robert Shiller of Yale University revived Graham and Dodd's suggestion in a 1988 paper. This suggested that the ratio of prices to ten-year average earnings was strongly correlated with returns over the next 20 years.

Shiller promoted the idea of a ten-year cyclically adjusted p/e ratio (aka Cape) in his book Irrational Exuberance, and hence it is sometimes known as the Shiller Cape. Some of the Cape's most notable successes have included indicating that the US stockmarket was extremely expensive ahead of the tech-bubble crash in the late 1990s, and also that it was unusually cheap after the 2008-09 financial crisis, even though the raw p/e was above 100.

The Cape has been shown to work with other global markets, too. Currently, the US market is particularly expensive compared with its long-term average on a Cape basis and has been for some time although in 1999 the S&P was even more overvalued than it is today.

See Tim Bennett's video tutorial: 'Cape' - Moneyweek's favourite valuation ratio.

Recommended

Misery index
Glossary

Misery index

The misery index is constructed by adding the unemployment rate to the inflation rate.
10 Sep 2021
Zombie company
Glossary

Zombie company

A zombie company is one that earns enough money to keep running, and to pay the interest on its debts, but not enough to expand, invest or to pay down…
17 Apr 2021
Margin call
Glossary

Margin call

When an investor borrows to bet on markets, they put down a deposit known as “margin”.
2 Apr 2021
Resource curse
Glossary

Resource curse

The term “resource curse” refers to the observation that countries with abundant natural resources also tend to be less economically developed than th…
14 Jan 2021

Most Popular

Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
Should investors be worried about stagflation?
US Economy

Should investors be worried about stagflation?

The latest US employment data has raised the ugly spectre of “stagflation” – weak growth and high inflation. John Stepek looks at what’s going on and …
6 Sep 2021
How you can profit from the power of the grey pound
Share tips

How you can profit from the power of the grey pound

Higher life expectancy and surging asset prices have proved a boon for the baby-boomer generation, which has accumulated vast wealth. Younger generati…
10 Sep 2021