Shiller P/E Ratio
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What Is the Shiller P/E Ratio?
The Shiller P/E Ratio, also known as the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, is a valuation measure that uses real (inflation-adjusted) per-share earnings over a 10-year period to smooth out fluctuations in corporate profits.
The Shiller P/E Ratio, named after Yale professor Robert Shiller, is a tool for assessing whether the stock market is overvalued or undervalued. Unlike the standard Price-to-Earnings (P/E) ratio, which looks at only one year of earnings (trailing or forward), the Shiller P/E looks at the average of earnings over the last 10 years, adjusted for inflation. This smoothing process is critical because corporate earnings are highly volatile. In a boom year, earnings spike, making the standard P/E look artificially low (cheap). In a recession, earnings collapse, making the standard P/E look artificially high (expensive). By averaging 10 years of data, the Shiller P/E (or CAPE - Cyclically Adjusted P/E) removes this noise to reveal the true underlying valuation trend. Shiller demonstrated that this ratio is a strong predictor of returns over the next 10 to 20 years. When the CAPE is high, subsequent long-term returns tend to be poor. When it is low, returns tend to be strong.
Key Takeaways
- The Shiller P/E accounts for inflation and business cycles by using a 10-year average of earnings.
- It was popularized by Nobel laureate Robert Shiller to predict long-term market returns.
- A high CAPE ratio typically implies lower future returns, while a low ratio implies higher returns.
- It is considered a better measure of long-term value than the standard P/E ratio, which can be volatile.
- The ratio is primarily used for valuing entire indices (like the S&P 500) rather than individual stocks.
How It Is Calculated
Shiller P/E = Current Price / Average(Inflation-Adjusted Earnings over last 10 years)
Interpreting the Ratio
* **Historical Average:** The long-term average for the S&P 500 is roughly 16-17x. * **Overvaluation:** Levels significantly above the average (e.g., above 25 or 30) suggest the market is expensive and potentially speculative. The ratio peaked near 44 before the dot-com crash in 2000. * **Undervaluation:** Levels significantly below the average (e.g., below 10 or 12) suggest the market is cheap and offers a good buying opportunity, as seen in the early 1980s. However, critics argue that changes in accounting rules and structural shifts in the economy (like the rise of high-margin tech companies) justify a structurally higher CAPE ratio today than in the past.
Advantages and Disadvantages
The Shiller P/E is a powerful macro tool but has limitations.
| Pros | Cons | |
|---|---|---|
| Smooths Volatility | Eliminates the distortion of one-off boom or bust years. | Backward-looking; uses data from 10 years ago. |
| Predictive Power | Strong correlation with 10-year future returns. | Terrible at predicting short-term market timing. |
| Inflation Adjusted | Accounts for the changing value of money. | Does not account for changes in tax rates or accounting standards. |
Real-World Example: The Dot-Com Bubble
The most famous application of the Shiller P/E was in the late 1990s. Scenario: In late 1999, the S&P 500 standard P/E ratio was high but arguably justifiable by "new economy" growth expectations. However, the Shiller P/E ratio climbed to over 44x—a level never before seen, surpassing even the 1929 peak (roughly 30x).
Important Considerations for Investors
The Shiller P/E is NOT a market timing tool. The market can remain "expensive" (high CAPE) for years before correcting. Selling stocks simply because the CAPE is above average can lead to missing out on significant gains (as happened to many bears in the 2010s). Instead, investors should use it to manage expectations: if the CAPE is high, plan for lower future returns and perhaps diversify into cheaper asset classes or regions.
FAQs
Historically, the average is around 16-17. However, in the modern era of low interest rates, many analysts consider a range of 20-25 to be "fair value." A ratio below 15 is generally considered cheap, while anything above 30 is considered very expensive.
It can be applied to individual stocks, but it is less effective than for indices. Individual companies undergo drastic changes over 10 years (mergers, business model pivots) that make a 10-year earnings average less relevant than it is for a broad index.
The regular P/E uses only 1 year of earnings. If earnings collapse by 50% in a recession, the regular P/E might skyrocket, making the market look expensive when it's actually bottoming. The Shiller P/E averages 10 years, so it remains stable, correctly identifying the market as cheap.
The yield curve is a bond market signal often used to predict recessions (when it inverts). The Shiller P/E is a stock market valuation signal used to predict long-term equity returns. They measure different things but are both key macro indicators.
The current ratio is updated regularly on Robert Shiller's website at Yale University and is widely reported on financial news sites like Multpl.com and GuruFocus.
The Bottom Line
The Shiller P/E Ratio is widely regarded as one of the most reliable indicators of long-term market valuation. By adjusting for inflation and business cycles, it offers a sober view of market prices that cuts through the noise of temporary earnings spikes or crashes. While it is a poor tool for timing the market in the short run, it serves as an excellent compass for setting long-term expectations. When the Shiller P/E is high, prudent investors might lower their return forecasts and ensure they are properly diversified. When it is low, it often signals a generational buying opportunity.
More in Valuation
At a Glance
Key Takeaways
- The Shiller P/E accounts for inflation and business cycles by using a 10-year average of earnings.
- It was popularized by Nobel laureate Robert Shiller to predict long-term market returns.
- A high CAPE ratio typically implies lower future returns, while a low ratio implies higher returns.
- It is considered a better measure of long-term value than the standard P/E ratio, which can be volatile.