What it means
An ordinary price to earnings ratio divides today's price by last year's profit. That works badly at the turning points of an economic cycle, because profits collapse in a recession and the ratio spikes, making shares look expensive at precisely the moment they are cheapest.
The reverse happens at the top of a boom, when record profits make the ratio look reassuringly low. The cyclically adjusted version fixes this by using the average of ten years of earnings, with each year's figure restated into today's money using an inflation index.
Ten years is chosen because it usually spans at least one full economic cycle, so a single exceptional year cannot dominate the answer. The result is a slower-moving denominator that reflects normal earning power rather than current conditions.
The ratio is used comparatively, not as an absolute verdict. A market with a CAPE of 32 against a long-run average of 17 is expensive by its own historical standard, which historically has been associated with lower returns over the following decade.
It says almost nothing about what will happen next year, which is why it is a poor timing tool and a reasonable expectation-setting one. There are real objections to using it mechanically.
Accounting standards change over time, the mix of businesses in an index shifts towards higher-margin sectors, and sustained changes in interest rates or tax rates can justify a permanently higher ratio. Comparing today's CAPE with a fifty-year average therefore risks comparing two different things.
For business people, the value is less in stock picking and more in framing decisions. A finance director considering an acquisition multiple, a founder judging whether to raise now or later, or a board setting a discount rate all benefit from knowing whether market valuations are historically stretched.
It is a check on assumptions rather than a forecast.
In practice
Real-world examples.
Example
A pension trustee reviewing a domestic equity allocation notes the market's CAPE has reached 33 against a long-run average near 17. Rather than sell out, the trustees lower their assumed ten-year return from 7% to 4.5%, which increases the contributions the scheme requires.
Example
A private investor compares two markets, one on a CAPE of 14 and another on 29. She shifts new contributions towards the cheaper market, accepting that the gap may reflect genuine differences in growth and governance rather than pure mispricing.
Example
A corporate development team benchmarks an acquisition target's asking multiple against the sector's cyclically adjusted level. Profits at the target have doubled in two years, so the team values it on ten-year average earnings and offers well below the headline ask.
Formula
Calculation
CAPE ratio = Current price / Average inflation-adjusted earnings per share over the past 10 years
The inflation adjustment restates each past year's earnings in today's money:
Adjusted earnings = Reported earnings x (Current price index / Price index in that year)
Take a company whose shares trade at $84. Ten years ago it reported earnings per share of $3.00, and cumulative inflation since then has been 25%.
Adjusted earnings for that year = $3.00 x 1.25 = $3.75.
Repeating that adjustment for each of the ten years and averaging the results gives an inflation-adjusted average of $4.20 per share.
CAPE ratio = $84 / $4.20 = 20.
Now compare this with the ordinary trailing ratio. The company earned $6.00 per share last year, an unusually strong result, so the trailing price to earnings ratio is $84 / $6.00 = 14. The plain ratio suggests a cheap share while CAPE suggests a fairly full one, and the difference is entirely explained by last year being well above the company's ten-year normal.Case study
Seen in the real world.
Fairmont Legacy Endowment is a fictional charitable fund used purely as an illustrative example. Its investment committee set spending each year at 5% of assets, an assumption built when equity markets traded on a CAPE of about 15 and long-run returns of 8% seemed reasonable.
After a long bull market, the CAPE on the fund's main equity market reached 34, more than double the level at which the spending rule had been set. The committee resisted the temptation to declare the market overvalued and sell, recognising that CAPE has repeatedly stayed elevated for years. Instead they treated it as information about future returns rather than about next year's direction.
In this illustrative scenario the committee cut the spending rate from 5% to 3.75%, extended the averaging period used to calculate the spending base from three years to five, and added an explicit review trigger if CAPE fell below 20. When markets did retreat two years later, the endowment's spending had already been set at a sustainable level and no emergency cuts to grant commitments were needed.
Watch out
Common mistakes.
- Using CAPE as a market timing signal. Markets have stayed expensive on this measure for a decade or more, and selling on a high reading has often meant missing years of gains.
- Forgetting the inflation adjustment. Averaging ten years of nominal earnings without restating them into current money understates the older years and flatters the ratio.
- Applying CAPE to a single young company. It needs ten years of earnings history and reasonably stable business conditions, so it suits broad indices and mature firms rather than recent listings.
Questions
People also ask.
Who developed the CAPE ratio?
It was popularised by economist Robert Shiller, which is why it is often called the Shiller price to earnings ratio.
Why ten years rather than five or twenty?
Ten years is long enough to span a typical economic cycle and smooth out one-off results, while still being recent enough to reflect the current business.
Does a high CAPE guarantee poor returns?
No, it has historically been associated with lower average returns over the following decade, but it is a broad tendency rather than a reliable prediction for any single period.
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