Shiller P/E Ratio

The Shiller P/E Ratio, also known as the Cyclically Adjusted Price-to-Earnings Ratio (CAPE), is a valuation measure of the stock market that incorporates inflation-adjusted earnings over a 10-year period. This ratio is used to assess whether a stock or the overall market is overvalued or undervalued based on historical averages.

Understanding Shiller P/E Ratio

The Shiller P/E Ratio is calculated by taking the current price of a stock or stock index and dividing it by the average inflation-adjusted earnings per share over the past 10 years. This approach helps to smooth out fluctuations in earnings that can occur due to economic cycles.

Calculation of Shiller P/E Ratio

The formula to calculate the Shiller P/E Ratio is:

Shiller P/E Ratio = Current Price / Average Inflation-Adjusted Earnings (10 years)

To arrive at the average inflation-adjusted earnings, the following steps are generally taken:

1. Calculate the earnings per share (EPS) for each of the past 10 years.
2. Adjust these earnings for inflation using the Consumer Price Index (CPI).
3. Compute the average of these adjusted earnings.

Example of Shiller P/E Ratio

Let’s consider a hypothetical stock with the following details:

– Current stock price: $100
– Earnings per share (EPS) over the past 10 years (inflation-adjusted):
– Year 1: $4
– Year 2: $5
– Year 3: $6
– Year 4: $7
– Year 5: $6
– Year 6: $5
– Year 7: $7
– Year 8: $8
– Year 9: $9
– Year 10: $10

1. Calculate the average EPS:
– Total earnings over 10 years = 4 + 5 + 6 + 7 + 6 + 5 + 7 + 8 + 9 + 10 = 57
– Average EPS = 57 / 10 = $5.70

2. Calculate the Shiller P/E Ratio:
– Shiller P/E Ratio = $100 / $5.70 ≈ 17.54

Interpreting the Shiller P/E Ratio

– A Shiller P/E Ratio significantly above its historical average may indicate that the market is overvalued, suggesting a possible market correction in the future.
– Conversely, a ratio below its historical average may indicate undervaluation, suggesting potential for future growth.

This ratio is particularly useful for long-term investors assessing the relative value of stocks or the overall market, making it an important tool for investment decision-making.