The P/E ratio is one of the most critical ratios for investors. It represents the ratio between a stock's price and the underlying company's earnings per share. This way, it helps investors can make decisions about their investments. However, the traditional P/E ratio may not provide information about a company's historical performance. For that, investors may use the cyclically-adjusted P/E ratio.
What is the Cyclically Adjusted P/E Ratio?
The cyclically-adjusted P/E (CAPE) ratio represents the ratio between a company’s stock price and its average earnings for the last ten years. Investors have to adjust these earnings for inflation before using them in the CAPE ratio. Therefore, it measures a company's real earnings per share over a given 10-year period. Using these earnings, investors can adjust for any fluctuations in financial performance caused by a nation's business cycle.
Other names used for the cyclically-adjusted P/E ratio include the Shiller Ratio and the PE 10 Ratio. The CAPE ratio can help investors gauge a company’s financial performance over several periods barring business cycle impacts. Therefore, it accounts for any fluctuations in a company’s profits due to economic expansions or recessions. Using this information, investors can ultimately decide whether a stock is undervalued or overvalued.
How to calculate the Cyclically Adjusted P/E Ratio?
As mentioned, the cyclically-adjusted P/E ratio is the ratio between a company’s stock price and real earnings for ten years. Therefore, the formula for the CAPE ratio is as below.
CAPE Ratio = Company’s stock price /Average earnings for ten years adjusted for inflation
A company's stock price is usually available through the stock market. For private companies, however, it may be challenging to calculate it. On the other hand, the average 10-year real earnings may also require investors to perform some analysis. Once done, however, it should allow smooth out the impact of business cycles on a company's financial performance.
How can investors use the Cyclically Adjusted P/E Ratio?
Investors can use the cyclically adjusted P/E ratio to measure a company's performance over a long period. Usually, the P/E ratio considers current or short-term results. Therefore, it may not be an indicator of a company's long-term performance. The cyclically adjusted P/E ratio solves that issue by considering the company's earnings for ten years. However, it also adjusts for any inflation during the period to account for business cycle impacts.
Investors can also use the CAPE ratio to forecast a company's future earnings. However, they shouldn't use this tool on its own. Overall, the CAPE ratio can allow investors to identify stocks that are undervalued or overvalued. When the calculated CAPE ratio for a company is significantly high, it may indicate its stocks are overvalued. On the other hand, low CAPE ratios indicate undervalued stocks.
Cyclically adjusted P/E ratios also play a significant role in identifying market bubbles. In this case, the P/E ratio may not be helpful. However, by calculating the ratio between a stock's price and its 10-year earnings, investors can get better results. A criticism of the CAPE ratio may include not adjusting for changes in accounting policies or standards. Investors should be aware of it when using the ratio.
Conclusion
The P/E ratio is one of the investors' favourite ratios to use when analyzing various stocks. However, it may not provide accurate information about a company's historical performance. For that, investors may use the cyclically-adjusted ratio. This ratio considers a company's stock price in relation to its earnings for ten years adjusted for inflation.
Article Source Here: Cyclically Adjusted P/E Ratio (CAPE)
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