The CAPE ratio stands for cyclically adjusted price-to-earnings ratio and is also known as the Shiller P/E, named after Yale University professor Robert Shiller, or the PE 10 ratio. It is a valuation measure that uses real earnings per share (EPS) over 10 years to smooth out fluctuations in corporate profits over different periods of a business cycle. The CAPE ratio is calculated by dividing the share price by the average of the company's earnings in the last ten years, adjusted for inflation.
The CAPE ratio is used to determine whether a stock is over- or under-valued or to analyze a publicly held company's long-term financial performance while considering the impact of different economic cycles on its earnings. The idea is that company earnings tend to be volatile and cyclical fluctuations and can significantly impact the traditional P/E ratio. The CAPE ratio smoothens out the fluctuations.
The CAPE ratio was first given attention when Robert Shiller and John Campbell presented research to the Federal Reserve in 1996, suggesting that the U.S.'s stock prices were increasing much faster than earning. In their 1998 article, "Valuation Ratios and the Long-Run Stock Market Outlook," Shiller and Campbell looked at earnings for the S&P 500 using the CAPE ratio of the past 10 years, going back to 1872. From their findings, the ratio was at a record 28 in January 1997, with the only other comparably high ratio occurring in 1929. Based on the ratio, they predicted that the market's real value would be 40% lower in ten years, which proved to be accurate as the 2008 market crash contributed to the S&P 500 plummeting 60% between October 2007 and March 2009. In June 2018, the CAPE ratio was 33.78, significantly higher than its long-term average of 16.80, only the second time the ratio exceeded 30, the other being in 1929. This sparked a debate about whether or not the ratio portends a significant market correction.
Different countries have different CAPE ratios; however, one country's ratio should not be compared to another country's ratio. The best way to evaluate a country's stock market (determine if it is undervalued or overvalued) is to compare a nation's current CAPE ratio to its historical average. Below is the CAPE ratio for the largest economies in the world as of June 30, 2020: