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 3 years’ earnings data and earnings are diluted and normalised.
The Price to Average Earnings Ratio measures the value of a share against its long run earnings. This is considered by some a better measure of a firm’s value as earnings can be volatile from year to year. Taking the average of a number of years’ worth of earnings gives us a better idea of the true earnings power of a firm.
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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