# CAPE Ratio Explained: Definition, Formula, and Market Insights

![CAPE Ratio](https://www.investopedia.com/thmb/m5-TLRk2N-pJ0z4oy3J1g0YVNSM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/CAPEratio_final-8763dd2ee6374f11ae15bf0b2dec3a05.png)

*— Nez Riaz / Investopedia*

## What Is the CAPE Ratio (Shiller P/E Ratio)?

The CAPE ratio, also known as the Shiller P/E ratio, assesses the stock market's pricing by adjusting past earnings for inflation over a decade. Popularized by Yale's Robert Shiller, it gives investors insight into whether markets are undervalued or overvalued based on historical earnings data.

### Key Takeaways

*   The CAPE ratio, or Shiller P/E ratio, uses real earnings per share (EPS) averaged over 10 years to adjust for economic cycles, helping investors assess market valuation. 
*   Popularized by economist Robert Shiller, the CAPE ratio assists in evaluating if stocks or broad equity indexes are undervalued or overvalued. 
*   Despite its widespread use, some critics argue that the CAPE ratio is less effective in predicting future market returns due to its backward-looking nature and reliance on GAAP earnings.
*   Historically high CAPE ratios can signal potential market corrections, as first observed in 1997 and later validated during the 2008 market crash.

## How to Calculate the CAPE Ratio

The CAPE ratio is calculated by dividing a stock's current share price by its average inflation-adjusted earnings over the past 10 years.  

$CAPE \text{ ratio} = \frac{\text{Share price}}{10 - \text{year average}, \text{ inflation} - \text{adjusted earnings}}$

## Understanding the Insights From the CAPE Ratio

Economic cycles greatly affect a company's profitability. During [expansions](https://www.investopedia.com/terms/e/expansion.asp), profits rise substantially as consumers spend more money, but during [recessions](https://www.investopedia.com/terms/r/recession.asp), consumers buy less, profits plunge, and can turn into losses. Profit swings are larger in cyclical sectors like commodities and financials, compared to more stable areas like utilities. However, most companies struggle to stay profitable during deep recessions.

Fluctuations in per-share earnings cause the price-to-earnings (P/E) ratios to vary widely. Because of this, Benjamin Graham and David Dodd recommended in their seminal 1934 book, "Security Analysis," that for examining valuation ratios, one should use an average of earnings over preferably seven or 10 years.

## Real-World Example of CAPE Ratio Application

The CAPE ratio gained attention in December 1996 when Robert Shiller and John Campbell showed the Federal Reserve that stock prices were rising faster than earnings. In 1998, Shiller and Campbell published an article showing they averaged the S&P 500's real earnings over 10 years, reaching back to 1872.

This ratio was at a record 28 in January 1997, with the only other instance (at that time) of a comparably high ratio occurring in 1929. Shiller and Campbell asserted that the ratio predicted that the real value of the market would be 40% lower in 10 years than it was at that time. That forecast proved to be remarkably prescient, as the [market crash of 2008](https://www.investopedia.com/terms/s/subprime-meltdown.asp) contributed to the S&P 500 plunging 60% from October 2007 to March 2009.

The CAPE ratio for the S&P 500 climbed steadily in the second decade of this millennium as the economic recovery in the United States gathered momentum, and stock prices reached record levels. As of June 2024, the CAPE ratio stood at 35.49, compared with its long-term average of 16.80. The fact that the ratio had previously only exceeded 30 in 1929 and 2000 triggered a raging debate about whether the elevated value of the ratio portends a major market [correction](https://www.investopedia.com/terms/c/correction.asp).

## Recognizing the Limitations of the CAPE Ratio

Critics say the CAPE ratio isn't very useful because it looks at past data instead of future trends. Another issue is that the ratio relies on [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) earnings, which have undergone marked changes in recent years.

In June 2016, Jeremy Siegel of the Wharton School published a paper in which he said that forecasts of future equity returns using the CAPE ratio might be overly pessimistic because of changes in the way GAAP earnings are calculated. Siegel argued that using consistent earnings data like operating earnings or NIPA profits, instead of GAAP earnings, enhances the CAPE model's ability to predict higher U.S. equity returns.

## What Does CAPE Stand for in CAPE Ratio?

“CAPE” in CAPE ratio stands for cyclically adjusted price-to-earnings. The ratio is also known as the Shiller P/E ratio, named for Yale University professor Robert Shiller, who popularized it.

## What Is the CAPE Ratio Applied to?

The CAPE ratio is generally applied to broad equity indexes to assess whether the market is undervalued or overvalued. However, critics contend that it is not very useful since it is inherently backward-looking and relies on generally accepted accounting principles (GAAP) earnings, which have undergone marked changes in recent years.

## When Did the CAPE Ratio First Gain Public Attention?

The CAPE ratio initially came into the spotlight in December 1996, after Robert Shiller and John Campbell presented research to the Federal Reserve that suggested stock prices were rising faster than earnings. They followed this up in the winter of 1998 with their article “Valuation Ratios and the Long-Run Stock Market Outlook.”

## The Bottom Line

The cyclically adjusted price-to-earnings (CAPE) ratio smooths out fluctuations in corporate profits by using real earnings per share (EPS) over a 10-year period, adjusting for inflation. Popularized by Robert Shiller, this measure helps determine whether markets are overvalued or undervalued. While it's a critical tool for long-term performance analysis, some criticize it for being backward-looking and reliant on GAAP standards that have evolved. Investors should consider these factors when applying the CAPE ratio to make informed market assessments.  

> **Article Sources**
>
> 1.  Benjamin Graham and David Dodd, via Google Books. “[Security Analysis](https://www.google.com/books/edition/Security_Analysis_The_Classic_1934_Editi/wXlrnZ1uqK0C).” McGraw-Hill Education, 1996.
>     
> 2.  Campbell, John Y., and Shiller, Robert J. “[Valuation Ratios and the Long-Run Stock Market Outlook: An Update](https://www.nber.org/system/files/working_papers/w8221/w8221.pdf).” _National Bureau of Economic Research_, Working Paper 8221, April, 2001.
>     
> 3.  YCharts. “[S&P 500 Shiller CAPE Ratio](https://ycharts.com/indicators/cyclically_adjusted_pe_ratio).”
>     
> 4.  Siegel, Jeremy J., via Taylor & Francis Online. “[The Shiller CAPE Ratio: A New Look](https://www.tandfonline.com/doi/epdf/10.2469/faj.v72.n3.1).” _Financial Analysts Journal_, vol. 72, no. 3, 2016, pp. 41–50.