Investors often use the price/earnings, or p/e, ratio, to judge whether a stock is cheap or not. It’s easy to calculate, hence its popularity. We’ve covered it in a previous video, but to sum up, you simply divide the share price of the company by its earnings per share.
A low number – below ten, say – suggests that you aren’t being asked to pay much for each pound or dollar of earnings the company makes. That might be because the stock is cheap. But it might instead be because investors expect earnings to fall in the future. A high number indicates that a stock may be expensive, or perhaps that investors expect earnings to grow rapidly.
However, the basic p/e is very flawed. Using just one year of profits means that a company – particularly one in a cyclical business, such as housebuilding – can look cheap because profits happen to be peaking at that point, and are set to fall hard when business turns down in line with the wider economy.
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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 should give investors a better view of whether a stock is really cheap compared to its average performance over an economic cycle.
Professor Robert Shiller of Yale University popularised this idea of the cyclically-adjusted price/earnings ratio – or Cape, for short – in his book Irrational Exuberance, which was published in 2000. That’s why it’s also sometimes known as the Shiller p/e.
Shiller and his colleagues found that investing in markets when the market-wide Cape was low tended to deliver strong returns over the following 20 years. Buying when the Cape was high, tended to lead to weaker returns. Shiller’s findings gained particular attention because his book was published just as the dotcom bubble burst, and US markets – which had never been more overvalued on a Cape basis – collapsed.
However, despite this apparent prescience, it’s important to note that Cape is not a tool for market timing. The US market has been expensive on a Cape basis for several years now, for example. Instead, it is a useful measure to look at when trying to find markets that have the potential to outperform in the long run.
To learn more about valuation measures, subscribe to MoneyWeek magazine.
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