The primary distinction between the Traditional Price-to-Earnings (P/E) Ratio and the Cyclically Adjusted Price-to-Earnings CAPE Ratio lies in their approach to measuring the “Earnings” component, fundamentally altering their purpose, volatility, and utility for investors.
The Traditional P/E Ratio: A Snapshot in Time
The Traditional P/E Ratio is the most common valuation metric, calculated by dividing the Current Stock Price by the company’s Earnings Per Share (EPS) over the trailing twelve months (TTM).
Traditional P/E = Current Stock Price / Trailing 12-Month EPS
This ratio is essentially a snapshot of current valuation, telling an investor how much they are paying for every dollar of a company’s most recent annual earnings.
However, its reliance on just one year of earnings makes it highly volatile and susceptible to being skewed by the business cycle.
During an economic boom, a company’s earnings may be temporarily inflated, leading to a misleadingly low P/E ratio that suggests the stock is cheap. Conversely, during a deep recession, earnings can collapse (or even turn negative), resulting in a very high or even meaningless P/E, which falsely suggests the stock is expensive.
Consequently, the traditional P/E ratio is best suited for short-term analysis and comparisons between peer companies in the same industry.
The CAPE Ratio: Smoothing the Business Cycle
The Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, often called the Shiller P/E or P/E 10, was popularized by economist Robert Shiller to address the volatility inherent in the traditional P/E.
Its core innovation is replacing the volatile 12-month earnings with a smoothed, long-term average.
CAPE Ratio= Current Stock Price / 10-Year Average Inflation-Adjusted EPS
The CAPE ratio works by dividing the Current Stock Price (usually of a broad index like the S&P 500) by the average of the previous ten years of earnings per share, adjusted for inflation.
This 10-year lookback is specifically chosen to encompass a typical full business cycle, ensuring that the denominator—the earnings figure—is a true reflection of the market’s sustainable earning power, unclouded by the temporary highs of a boom or the lows of a bust.
Because of this smoothing effect, the CAPE ratio exhibits lower volatility than the traditional P/E.
The Utility of CAPE
Unlike the traditional P/E, which is a gauge of current value, the CAPE ratio is a powerful tool for long-term analysis. It has historically demonstrated a strong inverse correlation with future stock market returns over the subsequent 10 to 20 years.
A historically high CAPE ratio suggests that the market is generally overvalued and investors should expect below-average returns in the coming decade, while a low CAPE ratio indicates potential undervaluation and suggests higher-than-average long-term returns.
It is, therefore, primarily used as a broad market barometer to assess the overall expensiveness or cheapness of an entire equity market, rather than an individual stock.