Updated August 2018
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.