The cyclically adjusted price-to-earnings (CAPE) ratio uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. The valuation measure analyzes a publicly held company’s long-term financial performance while considering the impact of different economic cycles on the company’s earnings. Value investors Benjamin Graham and David Dodd argued for smoothing a firm’s earnings over the past five to ten years in their classic text Security Analysis. Graham and Dodd noted one-year earnings were too volatile to offer a good idea of a firm’s true earning power.
Can the CAPE Ratio be applied to individual stocks?
The P/E 10 ratio also uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle. The P/E 10 ratio is also known as the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio. In other words, predicting future earnings cannot be accurate unless average earnings for five to ten years are considered and the results are adjusted for inflation. However, the earnings volatility rate is low during a more extended period as it smoothes out the fluctuations and business cycle consequences on the company’s earnings. The CAPE ratio, an acronym for cyclically adjusted price-to-earnings ratio, was popularized by Yale University professor Robert Shiller.