Ever wondered how investors figure out if the stock market is expensive or cheap? That’s where the CAPE Ratio comes in — a simple yet powerful way to see long-term market value. Let’s break it down step by step, in plain English.
What Is the CAPE Ratio?
The CAPE Ratio, also called the Shiller P/E Ratio, stands for Cyclically Adjusted Price-to-Earnings Ratio. It was introduced by Robert Shiller, a Nobel Prize–winning economist, to show whether the stock market is overvalued or undervalued compared to its historical average.
Unlike the normal P/E ratio, which uses just one year’s earnings, the CAPE Ratio uses 10 years of inflation-adjusted earnings. This helps smooth out short-term ups and downs.
In short: CAPE Ratio = Long-term market price ÷ Average inflation-adjusted earnings (last 10 years).
Step-by-Step: How to Calculate the CAPE Ratio
Step 1: Find the market price (index level)
Take the current level of the index — for example, the S&P 500 is at 5,000 points.
Step 2: Collect the last 10 years of earnings per share (EPS)
You’ll need the real EPS of the index for the past 10 years. Example (in ₹ or $ doesn’t matter): Yearly EPS = 150, 160, 155, 170, 175, 180, 190, 200, 210, 220.
Step 3: Adjust each year’s earnings for inflation
Use the Consumer Price Index (CPI) to make sure all earnings are inflation-adjusted. Let’s say after adjusting, the 10-year average earnings per share (EPS) is ₹180.
Step 4: Apply the CAPE Ratio formula
CAPE Ratio = Current Market Price ÷ Average Real EPS (10 years).
Now plug in the numbers: CAPE Ratio = 5,000 ÷ 180 = 27.7.
Step 5: Interpret the Result
So, the CAPE Ratio = 27.7.
A high CAPE Ratio (above 25–30) means the market might be overvalued. A low CAPE Ratio (below 15) means the market might be undervalued. A medium range (15–25) suggests a fairly valued market.
In simple words, the higher the CAPE Ratio, the more expensive the market looks based on its historical earnings.
Example: Comparing with History
Historically, the S&P 500 CAPE Ratio averages around 16–17. Before the 2000 dot-com bubble, it reached 44 — a sign of extreme overvaluation. During the 2008 crisis, it dropped below 15 — showing undervaluation.
That’s why many investors use the CAPE Ratio to judge long-term investing opportunities and market bubbles.
Why the CAPE Ratio Matters
The CAPE Ratio isn’t just for experts — it helps any investor understand market cycles and long-term value.
- It removes short-term noise from earnings.
- It adjusts for inflation — giving a true picture.
- It helps compare the current valuation with past decades.
- It’s a great tool for value investing and risk management.
Limitations of the CAPE Ratio
Even though it’s powerful, the CAPE Ratio isn’t perfect:
- It doesn’t predict exact market moves.
- Earnings can be distorted by accounting changes or one-time events.
- It’s better used for long-term insights, not short-term trades.
Think of it as a weather forecast — it tells you if it’s generally sunny or cloudy in the market, but not if it’ll rain tomorrow.
Final Thoughts
The CAPE Ratio is one of the smartest tools for understanding stock market valuation. By comparing current prices to 10 years of real earnings, it gives investors a clearer view of whether markets are cheap or expensive.
If you’re a long-term investor or just learning technical analysis and fundamentals, start tracking the CAPE Ratio — it’s a simple way to see what the big investors see.
Post a Comment