Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 576

This cornerstone of stock market valuation has been left behind

The Cyclically Adjusted Price to Earnings (CAPE) ratio, introduced by Nobel laureate Robert Shiller in 1988, has long been a cornerstone of market valuation metrics. 

By smoothing earnings over a decade, it aims to provide a more stable, long-term perspective on market valuations. However, the CAPE ratio’s limitations have become increasingly apparent, making it a potentially misleading tool, especially when used in isolation for valuing today’s dynamic markets.

Understanding the CAPE Ratio

The CAPE ratio is calculated by dividing the current market price of a stock or index by the average of inflation-adjusted earnings over the past ten years.

CAPE Ratio = Current Market Price / Average Inflation-adjusted Earnings of the Last 10 Years

This approach aims to normalize earnings over a full business cycle, reducing the impact of temporary factors that can distort traditional P/E ratios.

CAPE’s track record: A history of underestimation

Since its introduction in 1988, the CAPE ratio has consistently projected U.S. equity returns 5-10% (or more) below realized returns over various periods. Except for the tumultuous period from the dot-com bubble to the global financial crisis, following CAPE for allocation decisions would likely have led investors into 1) the wrong asset class, 2) the wrong countries, and 3) the wrong sectors.


Source: Aptus via Yale.edu

Below are three critical issues with the CAPE Ratio.

Issue 1: Static stock composition myth

The CAPE ratio assumes a constant mix of stocks over time, which fails spectacularly in today’s dynamic U.S. market. High-growth tech companies such as Apple, Microsoft, Nvidia, Google, Meta, and Amazon now dominate the index, with dramatically increased earnings and market weights over the past decade.

For example, the following table shows market weights of a handful of technology companies from ten years ago vs today.


Source: Aptus via Morningstar Data

This leads to a logically inconsistent valuation:

  • Price (numerator): Reflects current market cap that reflects their much larger present earnings
  • Earnings (denominator): Includes smaller weights and much lower earnings from up to a decade ago

Take NVIDIA as an example: The price component accounts for its current ~7% weight in the index that reflects its 6350% earnings growth that has taken place over the past decade. Yet the earnings component includes its tiny 0.06% weight and much smaller earnings from a decade ago.

This mismatch creates a distorted picture of what an investor is actually buying. It would only be logical if one expected these companies’ earnings to plummet by over 90%—an extremely unlikely scenario for established market leaders.


Source: Aptus via Morningstar Data

Issue 2: The buyback blind spot

The CAPE ratio fails to account for share buybacks, a key method companies use to return capital to shareholders. Unlike dividends, buybacks reduce the share count, increasing Earnings Per Share (EPS) even without a change in corporate earnings.

Consider two identical companies, differing only in capital return method:

  • Company A: Returns capital via dividends
  • Company B: Returns capital via buybacks

Assumptions for both companies are they have the same earnings, initial share prices, P/E ratios, business results, and policies of returning 100% of earnings to investors:

  • Constant 10x P/E ratio
  • 0% real EPS growth
  • 10% return (earnings of $1 per $10 share price)
  • 100% of earnings returned to investors

Over time this means:

  • Company A: $10 share price, 10% dividend yield
  • Company B: 10% annual reduction in shares, 10% increase in EPS and share price

Despite the identical businesses, the CAPE calculation shows company A with a CAPE of 10x and company B with a CAPE of 15.4x. This issue is particularly relevant in today’s US market, where buybacks are more prevalent than in the past. As a result, the current market’s CAPE ratio may not be directly comparable to its own history or to markets where buybacks are less common.


*Conceptual Illustration via Aptus

Issue 3: CAPE’s cross-market incompatibility

CAPE often paints U.S. stocks as more expensive than foreign markets. Direct comparisons between countries using CAPE ignore fundamental differences between markets. US companies are much more likely to buy back their stock than foreign companies and the U.S. market has experienced substantial earnings growth, unlike many foreign markets.

  • For a market with 0% EPS growth, the CAPE ratio remains constant.
  • For a market with 10% EPS growth, the CAPE ratio increases significantly over time, even if the trailing P/E remains the same.
  • Conversely, for a market with -2.5% EPS growth, the CAPE ratio decreases, even if the trailing P/E remains the same.


*Conceptual Illustration via Aptus

The U.S. market’s higher CAPE ratio often reflects higher EPS growth, not necessarily overvaluation.

Moving beyond CAPE

While historically significant, CAPE has become an increasingly flawed standalone valuation tool, particularly for the dynamic U.S. market. Its failure to account for changing stock composition, buybacks’ impact on EPS, and varying growth rates across sectors and markets can lead to misleading conclusions.

For modern investors, a more nuanced approach is essential. This should incorporate:

  • Multiple valuation metrics beyond CAPE
  • Analysis of sector-specific growth trends
  • Consideration of capital return strategies (dividends vs. buybacks)
  • Recognition of structural changes in market composition

By embracing a more comprehensive valuation framework, investors can navigate the complexities of today’s markets with greater accuracy and confidence. As the financial landscape continues to evolve, so too must our tools for understanding and valuing it.

 

Brian Jacobs, CFA is responsible for Investment Solutions and Strategy at Aptus Capital Advisors. This article is for informational purposes only and should not be considered a recommendation to purchase or sell any particular security. Be sure to consult with an investment and tax professional before implementing any investment strategy.

*Conceptual Illustration: Information presented in the above charts are for illustrative purposes only and should not be interpreted as actual performance of any investor’s account. As these are not actual results and completely assumed, they should not be relied upon for investment decisions. Actual results of individual investors will differ due to many factors, including individual investments and fees, client restrictions, and the timing of investments and cash flows.

 

RELATED ARTICLES

Finding single-digit PE stocks in an overvalued market

Is your fund manager skilful or just lucky?

Four tips to catch the next 10-bagger in early-stage growth

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.