The Cyclically Adjusted Price to Earnings Ratio, or CAPE Ratio, is a common long run valuation ratio used by equity investors. It is the price per share divided by earnings per share. This is an average of the past 10 years’ earnings data and earnings are diluted and normalised.
The Graham & Dodds Price to Earnings Ratio, commonly known as CAPE or Shiller P/E, is a valuation measure usually applied to stocks or equity markets. It is defined as price divided by the average of ten years of 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.
Decades later, Yale economist Robert Shiller popularised the 10-year version of Graham and Dodd's P/E as a way to value the stock market. Robert Shiller maintains a time-series of US CAPE here.
A high PE ratio means that investors are paying more for each unit of Earnings, so the stock is more expensive compared to one with a lower ratio. Investors have a tendency to overreact becoming enamoured with glamour stocks (pushing their PE too high) while becoming disenchanted with value stocks (pushing their PE too low).
Research has shown that low PE ratio stocks tend to outperform high PE stocks in the long run. Unlike the EV/EBITDA multiple which is capital structure-neutral, the price-to-earnings ratio reflects the capital structure of the company in question. The reciprocal of the PE ratio is known as the Earnings Yield.
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