Cyclically Adjusted Price-to-Earnings Ratio

• The Bottom Line: The CAPE ratio smooths out the volatile peaks and valleys of corporate earnings, giving you a clearer, long-term view of a stock's or market's true valuation.
• Key Takeaways:
• What it is: A valuation metric that compares the current price to the average, inflation-adjusted earnings over the past 10 years.
• Why it matters: It prevents investors from being fooled by a single year of unusually high or low profits, which is a common trap of the standard price_to_earnings_ratio.
• How to use it: To assess whether an individual stock or the entire market is historically cheap or expensive, helping you establish a crucial margin_of_safety.

Imagine you're thinking of buying a small farm. To judge its value, you could look at how much profit it generated last year. But what if last year had perfect weather, leading to a record-breaking harvest? Or what if a severe drought wiped out half the crops? A single year's performance is a terrible guide to the farm's long-term potential. You'd be either overpaying based on a lucky year or walking away from a bargain based on a bad one. A smarter approach would be to look at the farm's average profit over the last ten years. This would smooth out the bumper crops and the droughts, giving you a much more reliable picture of its true, underlying earning power. This is precisely what the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio does for stocks. Also known as the “Shiller P/E” or “P/E 10 Ratio,” ¹⁾ it doesn't just look at last year's earnings. Instead, it takes the average of the last ten years of a company's earnings and adjusts them for inflation. It then compares this stable, long-term earnings figure to the current stock price. The result is a powerful valuation tool that filters out the short-term noise of economic booms and busts—the so-called business cycles. It helps you answer a fundamental question for any value investor: “Am I buying this company's long-term earning power at a sensible price, or am I getting caught up in temporary euphoria or panic?”

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” - Benjamin Graham

The standard P/E ratio is the market's “vote” based on today's mood. The CAPE ratio is the market's “weight,” measured over a decade. For a value investor, the weight is what truly matters.

The CAPE ratio is not just another piece of financial jargon; it is a tool that directly supports the core tenets of value_investing. For the disciplined investor, it is an indispensable ally in a world obsessed with short-term performance.

• It Enforces Patience and a Long-Term Perspective: Value investing is a marathon, not a sprint. The CAPE ratio's 10-year window forces you to adopt this mindset. It shifts your focus from “What did the company earn last quarter?” to “What is the durable, underlying earning power of this business over an entire economic cycle?” This perspective is the bedrock of building long-term wealth and avoiding the frantic, often-disastrous, churn of short-term trading.
• It's a Powerful Antidote to Market Hysteria: Our minds are wired for narrative. During a bull market, it's easy to believe stories of a “new era” where profits will grow to the sky forever. A company's P/E ratio might look reasonable because its most recent year's earnings were spectacular. The CAPE ratio acts as a cold, rational anchor. By including the less-rosy years in its average, it can reveal that valuations are dangerously stretched, helping you sidestep bubbles. Conversely, during a recession, when mr_market is in a panic and P/E ratios are distorted by temporarily depressed earnings, the CAPE ratio can highlight the enduring strength of a business, revealing a historic buying opportunity.
• It Helps You Identify a True Margin of Safety: The single most important concept in value investing, championed by Benjamin Graham, is the margin of safety—buying a security for significantly less than its underlying intrinsic_value. The CAPE ratio is a brilliant tool for this. When you buy a solid company at a low CAPE ratio relative to its history, you are essentially purchasing a decade's worth of normalized earning power at a discount. This provides a buffer against unforeseen problems, bad luck, or errors in your own judgment. A low CAPE doesn't guarantee success, but it dramatically stacks the odds in your favor.

While data providers often calculate the CAPE ratio for you, especially for major indices like the S&P 500, understanding its construction is key to using it wisely. You're not just looking at a number; you're looking at a story told over ten years.

The formula itself is straightforward: CAPE Ratio = Current Stock Price / 10-Year Average of Inflation-Adjusted Earnings per Share (EPS) Let's break down how to get the denominator, which is the heart of the calculation:

1. Step 1: Gather the Data. Find the company's reported Earnings Per Share (EPS) for each of the last 10 full years.
2. Step 2: Adjust for Inflation. This is a critical step. An earning of $1 in 2014 is not the same as $1 in 2024 due to inflation. You must convert each of the past 10 years' EPS figures into today's dollars. You can do this using a historical Consumer Price Index (CPI) table. ²⁾
3. Step 3: Calculate the Average. Add up these 10 inflation-adjusted EPS figures and then divide the sum by 10. This gives you the “E10” – the cyclically adjusted, real earnings number.
4. Step 4: Divide the Price. Take the current stock price (the “P”) and divide it by the average earnings (the “E10”) you just calculated.

The result is the CAPE ratio.

A CAPE ratio is meaningless in isolation. A CAPE of 22 is neither “good” nor “bad” on its own. Its power comes from context and comparison, primarily against its own historical range.

• A High CAPE Ratio: When the CAPE is significantly higher than its long-term historical average (for the S&P 500, the historical average is around 17), it suggests that the market or stock is expensive. This implies that investors are paying a high price for each dollar of long-term, normalized earnings. For a value investor, this is a signal for caution. It indicates a small or non-existent margin of safety and often foreshadows lower long-term returns (e.g., over the next 10-15 years). It does not mean a crash is imminent, but it does mean the risk-reward proposition is less favorable.
• A Low CAPE Ratio: When the CAPE is significantly below its historical average, it suggests the market or stock is cheap. This typically occurs during periods of economic distress and widespread pessimism. While scary, these are the periods that create life-changing opportunities for the rational investor. A low CAPE indicates that you can buy a decade of earning power for a low price, creating a substantial margin of safety. Historically, low starting CAPE ratios have been strongly correlated with high subsequent long-term returns.
• The “This Time Is Different” Trap: Be wary of arguments that structural changes in the economy (e.g., lower interest rates, different sector weightings) permanently justify a higher average CAPE. While these factors can have an influence, human psychology and the principle of mean_reversion have a long and powerful history. A value investor acknowledges potential structural shifts but remains skeptical and demands a margin of safety regardless of the popular narrative.

Let's compare two fictional companies to see the CAPE ratio in action. Both currently trade at a price of $200 per share.

Based on a simple P/E ratio, CycleCo looks like a screaming bargain at a P/E of 10, while SteadyMed looks expensive at 25. An investor focused only on the last year might rush to buy CycleCo. However, the value investor digs deeper. They discover that CycleCo just had its best year in a decade due to a massive, one-time government infrastructure project. Its long-term average earning power is much lower. The CAPE ratio of 20 reflects this, showing the stock is not as cheap as it appears. Meanwhile, SteadyMed had a difficult year due to a product recall that temporarily depressed earnings. Its standard P/E looks terrible. But its business is fundamentally sound, and its 10-year average earnings are strong and stable. Its CAPE ratio of 21 shows that, relative to its long-term earnings power, it's actually valued similarly to CycleCo. The CAPE ratio helped us look through the short-term noise—a cyclical peak for one company and a temporary trough for the other—to get a much more accurate picture of their relative value.

No single metric is a silver bullet. The wise investor understands a tool's strengths as well as its weaknesses.

• Smooths Out Business Cycles: This is its greatest strength. It prevents you from overpaying at the peak of a boom or panic-selling at the bottom of a bust by focusing on the long-term trend.
• Promotes a Long-Term View: By its very design, the CAPE ratio forces you to think like a business owner, not a speculator. It aligns perfectly with the patient philosophy of value_investing.
• A Strong Historical Indicator: While not a timing tool, the starting CAPE ratio has historically been one of the most reliable predictors of future long-term (10+ years) returns. Low starting CAPEs have generally led to high returns, and vice-versa. ³⁾

• It is NOT a Market Timing Tool: This is the most critical pitfall to avoid. A high CAPE can remain high for many years, and a low CAPE can get even lower. The market can remain “irrational” longer than you can remain solvent. The CAPE ratio tells you about the level of risk and potential future return; it does not tell you what will happen next month or next year. Using it to time market tops and bottoms is a form of speculation, not investing.
• Changes in Accounting Rules: Accounting standards evolve. The way companies report earnings today (e.g., under GAAP or IFRS) is different from how they did 30 or 50 years ago. This can create some “apples-to-oranges” comparisons when looking at very long historical data.
• Structural Economic & Market Shifts: The economy is not static. The S&P 500 today, dominated by capital-light technology and service companies, is very different from the index in 1970, which was full of heavy industrial and manufacturing firms. One could argue these structural shifts might justify a higher average CAPE ratio today. A value investor should consider this but treat the claim with healthy skepticism.
• It Ignores the Interest Rate Environment: Valuation doesn't happen in a vacuum. Interest rates act like gravity on asset prices. In a world of very low interest rates, investors are willing to pay more for future earnings, which can push up all valuation metrics, including CAPE. However, relying on low rates to justify a high price is dangerous, as that support can be removed if rates rise.

• price_to_earnings_ratio
• margin_of_safety
• intrinsic_value
• mr_market
• mean_reversion
• business_cycle
• value_investing