CAPE Ratio

CAPE Ratio: The CAPE Ratio, or Cyclically Adjusted Price-to-Earnings Ratio, is a valuation measure used to assess whether a Stock or Stock market is overvalued or undervalued. It is calculated by taking the current price of a Stock or Index and dividing it by the average of the past 10 years of inflation-adjusted Earnings Per Share (EPS). This approach smooths out fluctuations in earnings that can occur due to economic cycles, providing a more stable measure of valuation.

Formula:

CAPE Ratio = Current Price / Average Inflation-Adjusted EPS (last 10 years)

Example 1: If a company’s current Stock price is $100 and its average inflation-adjusted EPS over the past 10 years is $5, the CAPE Ratio would be:

100 / 5 = 20

Example 2: If a market Index has a current price of 1,500 and its average inflation-adjusted EPS over the last decade is 75, the CAPE Ratio would be:

1,500 / 75 = 20

Case Study: During the dot-com bubble in the late 1990s, the CAPE Ratio for the S&P 500 reached extraordinarily high levels (above 40), indicating that the market was significantly overvalued. Conversely, during the Great Financial Crisis in 2009, the CAPE Ratio dropped to around 13, suggesting that the market was undervalued.