CAPE Ratio Explained

The CAPE Ratio (Cyclically Adjusted Price-to-Earnings Ratio) measures a stock market’s valuation by comparing current prices to average inflation-adjusted earnings over the past 10 years. It helps investors assess whether the market is overvalued or undervalued.

The CAPE Ratio (Cyclically Adjusted Price‑to‑Earnings Ratio), also known as the Shiller P/E or P/E‑10, smooths out short‑term earnings fluctuations by averaging real earnings over the past ten years. It helps investors assess whether a market is undervalued, overvalued, or fairly priced relative to its historical norms.

To see CAPE in action, consider how it's applied to broad stock market indices during different periods. For example, before and after market bubbles such as the Dot‑com boom, CAPE values rose sharply, signalling overvaluation. Meanwhile, during market downturns or after corrections, CAPE tends to fall below long‑term averages.

While CAPE is often used for indices, it can also be applied to individual companies. However, using it at company level has challenges: earnings can be erratic, accounting practices might differ, and inflation adjustments might be harder to implement accurately. For that reason, CAPE is more reliable when used across broad markets rather than individual firms.

Historically, CAPE values have varied significantly. In many major markets, long‑term average CAPE tends to hover around mid‑teens to low‑20s. At times, CAPE has reached levels above 30 during irrational optimism, and during crises or post‑crash periods, it has dropped well below average. These shifts often align with bull and bear cycles.

The CAPE Ratio matters because it:

• Helps assess long‑term market valuation rather than short‑term volatility.
  

• Provides perspective on long-term return expectations. When CAPE is high, expected returns over the next decade tend to be lower.
  

• Provides context for understanding asset allocation discussion between equities and safer assets.
  

• Serves as an early warning signal for potential overvaluation or bubble risk.

It also has drawbacks:

• CAPE uses past earnings, which may not reflect future trends, risks, or structural market changes.
  

• Inflation adjustments and accounting standards can vary over time, making historical comparisons imperfect.
  

• CAPE doesn’t account for changes in business models, regulations, or industry structures that may affect companies differently.
  

• It may not be very helpful for short‑term trading or timing decisions, as market sentiment or shocks can override valuation signals.

The CAPE Ratio is a valuable tool for those interested in long‑term valuation of markets. It smooths out earnings over time, offering perspective beyond what annual P/E ratios provide. But it should be interpreted with caution, understanding its limitations. When used alongside fundamentals, macroeconomic context, and forward‑looking indicators, CAPE is one of several metrics used in long-term valuation analysis.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.