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Spend your way onto the property ladder! I received a mailshot offering free entries into the National Lottery – is it a scam? How can I tell if a market or share is cheap or expensive? The CAPE or Shiller PE ratio explained By Tanya Jefferies for Thisismoney. Read this: How can I tell if a market or share is cheap or expensive?
I’ve heard about something called CAPE or the Shiller PE ratio which can tell you what markets or stocks are cheap or expensive right now. This sounds very useful, so how does it work? Are there any online tools or calculators that can do this for you, or is it something I can work out for myself? What sums would I have to do to find out if Tesco shares are cheap? Tanya Jefferies of This is Money replies: Markets and companies can be analysed in many different ways but one of the most common measures is the cyclically adjusted price earnings ratio or CAPE.
It broadly means price divided by the average of 10 years of earnings adjusted for inflation, and it’s a popular, although not infallible, measure of whether markets or individual stocks are cheap or expensive on a historical basis. Skyscrapers, the fear index, hemlines and burgers: Which financial indicators are worth following? CAPE is also often called the Shiller PE ratio after the influential American economist and Nobel Prize winner Professor Robert Shiller. Its usefulness or otherwise is a matter of debate and sometimes controversy, especially in the US where two different factions – the Shillerites and non-Shillerites – are currently slugging it out over whether stocks are over or under-valued. This is Money Editor Simon Lambert interviewed US CAPE investor Mebane Faber about his Global Value book and strategy that uses the ratio to invest in the cheapest markets around the world.
Tom Stevenson, investment director at Fidelity Personal Investing, replies: The cyclically-adjusted price-earnings ratio, or CAPE, was devised by Professor Robert Shiller, at Yale University. That is why it is sometimes known as the Shiller Ratio. It is a variant of the most commonly-used measure of the value of a share or market, the simple price-earnings ratio or PE. So Company A with shares priced at 100p and earnings per share of 10p would have a PE of 10. Company B, with shares priced at 240p and earnings per share of 12p, would have a PE of 20.
Broadly, an investor looks to buy when the PE is low and might consider selling if the PE rises to a high level. Here, all other things being equal, Company A looks slightly cheaper than Company B. Of course, other things are never equal, so an investor also needs to look at how reliable the companies’ earnings are and how fast they are growing. Where the CAPE differs from a simple PE is the way in which, rather than using one year’s earnings per share, it uses an average of the last 10 years’ earnings. As a result the ratio is also sometimes known as the PE10.
The idea is that a long-term average can provide a more reliable picture of a company’s earnings. The 10-year average is in theory less prone to big swings if, for example, earnings per share fall sharply during a recession. The CAPE also makes an adjustment for inflation so that the earnings in year one can be sensibly compared with the earnings in year ten. Because the CAPE uses data going back over 10 years, the average earnings figure will tend to be lower than the most recent earnings for a company that is expanding. This means that the CAPE tends to be higher than the simple one-year PE. Fans of the CAPE say that it is a better guide to future performance than the simple PE. Critics of it say that it is difficult to make meaningful comparisons over time because 10-year periods can differ so much from each other.
For me, the main problem with the CAPE is how to get hold of reliable data covering a 10-year period. Without access to an expensive database, this is not going to be possible for most individual investors. I have found one online CAPE calculator but it only covers US shares. Doing the calculations yourself is also quite difficult, not least because earnings can be hard to compare accurately between years if, for example, a company issues new shares or there is some other change to its structure like a big disposal. The second drawback, in my opinion, is that long-term averages work better for markets than for individual shares. To understand why, take a company like Google, which has grown enormously over 10 years. It is questionable whether an average of its earnings over that period is really meaningful.
By contrast, an established but slow-growth company that has been around for years but is not going anywhere could have a relatively low CAPE but might not be such an attractive investment. As importantly, it is very easy for an investor to quickly find the latest earnings and share price of any company online or in a newspaper. This means they can easily compare the value of different shares. The comments below have not been moderated. We are no longer accepting comments on this article. When is a good time to start investing – and how can you cut the risks? Where are the best places to invest in 2018 – and will UK shares be one of them?