P/E 10 Ratio (CAPE / Shiller PE)

Definition

The P/E 10 ratio, also called the cyclically adjusted price-to-earnings (CAPE) ratio or Shiller PE, is a valuation measure that divides a market’s current price level by the average of its inflation‑adjusted earnings per share (EPS) over the previous 10 years. It smooths earnings through business cycles to reduce the influence of short‑term profit swings.

Why it matters

Smoothing earnings over 10 years helps reduce the impact of cyclical peaks and troughs on valuation.
Historically, lower CAPE values have been associated with higher subsequent long‑term equity returns, and higher CAPE values with lower future returns.
Useful for long‑term valuation comparisons across periods, especially for broad market indices (e.g., the S&P 500).

Historical context

The idea of using multi‑year average earnings traces back to Benjamin Graham and David Dodd, who recommended multi‑year EPS averages to reduce noise in valuation.
Robert Shiller popularized the 10‑year inflation‑adjusted variant (CAPE) and documented long historical series for U.S. equities, showing wide historical variation (e.g., a low near 4.8 in 1920 and a high near 44.2 in 1999). Long‑term averages are often cited around the high teens.

How to calculate the P/E 10 (CAPE)

Collect annual EPS for the index or market for the past 10 years.
Adjust each year’s EPS for inflation (convert to today’s dollars, commonly using CPI).
Compute the arithmetic mean of those 10 inflation‑adjusted EPS figures.
Divide the current market price level (index level) by the 10‑year average real EPS:
CAPE = Current price / (Average of 10 years of real EPS)

Simple hypothetical example:
– Current index level = 3,000
– 10‑year average inflation‑adjusted EPS = 150
– CAPE = 3,000 / 150 = 20

Interpretation and common uses

Higher CAPE → market appears more expensive relative to long‑run earnings; historically associated with lower long‑term returns.
Lower CAPE → market appears cheaper; historically associated with higher long‑term returns.
Often used by long‑term investors, asset allocators, and researchers to assess whether markets are likely to be over‑ or undervalued relative to history.

Limitations and criticisms

Structural changes: Changes in accounting standards, tax policy, corporate payout behavior, and the prevalence of share buybacks can affect EPS and make historical comparisons imperfect.
Interest rates and risk premia: CAPE does not explicitly incorporate prevailing interest rates or investors’ required returns.
Profit margin regime shifts: If corporate profit margins have shifted to a new, persistent level, a historical average may understate sustainable earnings.
Not a market‑timing tool: CAPE can remain elevated or depressed for long periods; it is a valuation indicator, not a precise short‑term timing signal.
Data considerations: Early historical earnings series may include estimates; careful use requires consistent, reliable EPS and inflation data.

Practical advice

Use CAPE as one input among many (macroeconomic indicators, interest rates, balance‑sheet metrics, valuation multiples, qualitative factors).
Consider adjusting or complementing CAPE to reflect structural changes (e.g., normalized profit margins) if justified by evidence.
For portfolio decisions, focus on multi‑year horizons rather than expecting short‑term reversals based solely on CAPE.

Key takeaways

The P/E 10 (CAPE) smooths real earnings over 10 years to reduce cyclical noise in valuation.
It is useful for long‑term valuation comparisons but has well‑documented limitations.
Interpret CAPE alongside other data and avoid using it as a sole market‑timing indicator.

P/E 10 Ratio