The Use and Misuse of the CAPE Ratio

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This article originally appeared on ETF.COM here.

The Shiller cyclically adjusted (for inflation) price-to-earnings ratio – referred to as the CAPE 10 because it averages the last 10 years’ earnings and adjusts them for inflation – is a metric used by many to determine whether the market is undervalued, fairly valued or overvalued.

Employing a 10-year average for earnings, instead of the most current 12-month earnings, was first suggested by legendary value investors Benjamin Graham and David Dodd.

Birth of the CAPE

In their classic 1934 book “Security Analysis,” Graham and Dodd noted that traditionally reported price-to-earnings ratios can vary considerably because earnings are strongly influenced by the business cycle. To control for the cyclical effects, Graham and Dodd recommended dividing price by a multiyear average of earnings and suggested periods of five, seven or 10 years.

Then, in a 1988 paper, economists John Campbell and future Nobel Prize-winner Robert Shiller, using a 10-year average, concluded that a long-term average does provide information in terms of future returns. This gave further credibility to the concept, and led to the popular use of the CAPE 10.