Cyclically Adjusted P/E Ratio (CAPE): The Long-Run Valuation Guide
The standard P/E ratio has a problem: it measures valuation using earnings from a single year, which can be at a cyclical peak or trough. A company in the depths of a recession with temporarily crushed earnings will show a very high P/E even if the stock is actually cheap. A company at the top of an economic boom will show a low P/E even if the stock is dangerously expensive.
Yale economist Robert Shiller and Harvard's John Campbell developed the Cyclically Adjusted P/E ratio (CAPE) to solve this problem. By averaging 10 years of inflation-adjusted earnings, CAPE eliminates short-term cycle noise and provides a cleaner long-run valuation signal.
This article is for educational purposes only and does not constitute financial advice.
The CAPE Formula
CAPE = Current Price / 10-Year Average of Inflation-Adjusted EPS
Step-by-step calculation:
- Gather the last 10 years of earnings per share (reported, not adjusted)
- Adjust each year's EPS for inflation using the Consumer Price Index (CPI), converting all figures to current-year dollars
- Average the 10 inflation-adjusted EPS figures
- Divide the current share price by this 10-year average
Why 10 years? The business cycle typically runs 5-10 years from peak to peak. Averaging over 10 years means the calculation includes roughly one full cycle, capturing both the expansion and contraction phases. Single-year EPS can be as much as 50-80% below or above the cyclically-normal level during extremes.
Historical CAPE Readings and What Followed
The power of CAPE as a forecasting tool comes from its historical track record predicting long-run returns:
CAPE in the 5-9x range (1930s-1940s, certain 1970s periods): Extremely depressed valuations. Investors who purchased at these levels captured extraordinary returns over subsequent decades.
CAPE 10-15x (historical "normal" range): Moderate valuations. Forward 10-year returns have generally been average to above-average (7-10% annually) from these levels.
CAPE 16-22x: Slightly elevated. Forward 10-year returns have generally been modest but positive (4-8% annually).
CAPE above 25x: Historically expensive. Subsequent 10-year real returns have often been below average, sometimes negative in real terms.
CAPE above 30x: Extreme readings occurred primarily in two periods: the dot-com bubble (peaking near 44x in December 1999) and the 2017-2021 market environment (consistently above 30x).
The prediction is probabilistic, not deterministic. CAPE above 30x does not guarantee poor returns -- it is associated with historically below-average returns on average.
The Math Behind Why High CAPE Predicts Low Returns
There is a mechanical logic to why CAPE (or any valuation multiple) predicts returns.
Total stock market returns come from three sources:
- Dividend yield (income)
- Earnings growth
- Change in valuation multiple (multiple expansion or contraction)
When CAPE is extremely high, the valuation multiple can only stay flat or contract -- it cannot expand indefinitely. If EPS grows at historical rates (roughly 1-2% real annually for the broad market) and the multiple compresses from 35x to 20x over 10 years, returns are significantly impaired even with healthy earnings growth.
Conversely, when CAPE is extremely low, the combination of high dividend yields and even modest multiple expansion can produce very strong returns.
Limitations and Criticisms of CAPE
CAPE has faced several substantive criticisms. Understanding these is important for applying the metric correctly:
Criticism 1: Changes in Earnings Measurement
Over the decades, accounting standards have changed how earnings are reported. Particularly after the 2001 goodwill impairment rules and later changes to financial reporting, one-time write-downs and restructuring charges have been more aggressively reported in GAAP earnings. This means modern earnings figures may be systematically more conservative (lower) than historical equivalents, making modern CAPE artificially elevated relative to its own historical average.
Criticism 2: Structural Change in the S&P 500
The composition of the S&P 500 has shifted dramatically toward technology and other high-margin sectors. The index now has structurally higher profit margins than its historical average. Higher margins support higher sustainable P/E ratios. Comparing the current CAPE to historical averages that include decades of lower-margin industrial composition may be an apples-to-oranges comparison.
Criticism 3: CAPE Has Been High for 30 Years
Critics point out that CAPE exceeded its historical average of ~16x in 1991 and has been above that level almost continuously since. An investor who sold equities when CAPE first exceeded 20x in the mid-1990s would have missed one of the greatest bull markets in history. CAPE is clearly not a market-timing tool.
Criticism 4: Interest Rate Effects
At very low interest rates, higher equity multiples are theoretically justified because the risk-free rate is lower. Many analysts argue that comparing CAPE to its historical average in a higher-rate environment (1960s-1990s) versus a lower-rate environment (2010s-present) is not appropriate.
The Shiller CAPE Yield: A Rate-Adjusted Version
To address the interest rate criticism, some analysts use the Shiller CAPE Yield (also called Excess CAPE Yield):
Excess CAPE Yield = (1/CAPE) - 10-Year Treasury Real Yield
The Excess CAPE Yield measures how much more equity investors earn (on a CAPE basis) relative to the real yield available on government bonds. When this spread is wide, equities are attractive relative to bonds. When it is narrow or negative, bonds are more competitive with equities.
This adjustment helps contextualize CAPE readings across different interest rate environments, addressing one of the major criticisms.
How to Use CAPE in Practice
For strategic asset allocation:
CAPE is most useful as a decade-level return forecast, informing long-run strategic asset allocation decisions rather than tactical trading. An investor with a 10-15 year horizon who observes CAPE at extreme levels might modestly reduce equity allocation in favor of international stocks, real assets, or other asset classes with more attractive relative valuations.
For international diversification:
CAPE varies dramatically across countries. Historically, countries with depressed CAPEs have tended to outperform over subsequent decades. CAPE for many international developed markets and emerging markets has often been significantly cheaper than the US market, providing a rationale for geographic diversification beyond home-country bias.
For sector-level analysis:
Within the US market, sector-level CAPE analysis can identify relatively cheaper sectors. A sector trading at a CAPE well below its historical average may offer better forward returns than a sector at historically elevated valuations, even if the market-wide CAPE is high.
At the individual company level:
CAPE concepts apply to individual stocks too. A company with a normalized P/E (price divided by 10-year average earnings) significantly below its peer group may represent relative value. This is particularly relevant for cyclical businesses where single-year earnings are highly distorted.
CAPE vs. Other Long-Run Valuation Metrics
CAPE is most reliable when confirmed by other long-run valuation measures:
Tobin's Q: Compares market value to asset replacement cost. When both Q and CAPE are elevated, the market overvaluation signal is more robust.
Price-to-Sales: Less subject to earnings measurement issues. If P/S is also historically elevated, it corroborates the CAPE signal.
Free Cash Flow Yield: The aggregate FCF yield of the market provides a cash-based cross-check on earnings-based CAPE.
Market Cap to GDP (Buffett Indicator): Compares total equity market value to GDP. A rough measure of how expensive equities are relative to the economic output they are claims on.
When multiple long-run indicators align, the valuation signal is more credible than any single metric.
The Bottom Line
CAPE is not a market timing tool, and it is not perfect. But it is the most empirically validated long-run valuation indicator available for the stock market, backed by more than 130 years of data and a track record that predates almost every other financial metric in common use today.
Use it for decade-level return expectations and strategic allocation, not for deciding whether to buy or sell next month. Combine it with Tobin's Q, FCF yield, and international valuation comparisons for the most complete picture.
And remember: the point of CAPE is not to time the market perfectly -- it is to avoid paying extremely high prices for future earnings that may not materialize for a very long time.
All content is for educational purposes only. This is not financial advice. Always conduct your own due diligence before making investment decisions.