The standard PE ratio can mislead during booms and busts. The Shiller PE ratio, also called the cyclically adjusted price to earnings ratio or CAPE ratio, solves this problem. Created by economist Robert Shiller, it smooths out earnings over ten years to give a clearer view of stock market value. This guide explains how this tool works and how investors can use it to forecast future returns and make better decisions.
What Is the Shiller PE Ratio?
The Shiller PE ratio divides the current price of the S&P 500 by the average of inflation adjusted earnings over the past ten years. Robert Shiller developed this metric to address a key flaw in standard price to earnings ratios. Regular PE ratios use only one year of earnings. That single year can be unusually high during booms or unusually low during recessions, making the ratio unreliable.
By averaging historical earnings over ten years, the CAPE ratio removes the effect of short term earnings swings. The result is a more stable and meaningful measure of how expensive the stock market truly is. The cyclically adjusted price to earnings approach captures a full business cycle, giving investors a better foundation for long term decisions.
How to Calculate the CAPE Ratio
The formula has three steps. First, gather the earnings per share data for the S&P 500 over the past ten years. Second, adjust each year's earnings for inflation to express them in today's dollars. These are the inflation adjusted earnings. Third, divide the current S&P index price by the average of those ten years of inflation adjusted earnings.
For example, if the S&P 500 trades at 4,500 and the average of ten years of inflation adjusted earnings is 150, the CAPE ratio equals 30. This means investors are paying 30 times the average decade of real earnings for the S&P index. Most financial websites publish the current Shiller PE ratio, so manual calculation is rarely needed.
What the Numbers Mean
The long term average CAPE ratio for the S&P 500 sits near 17. Readings below 15 have historically signaled undervaluation. Readings between 15 and 25 fall within a normal range. Values above 25 suggest the stock market is expensive. Readings above 30 have preceded several major market downturns, including the dot com bubble.
Before the dot com bubble burst in 2000, the CAPE ratio reached 44. This was a clear warning that price to earnings ratios had become extreme. After the crash, the ratio fell below 14. These extreme readings demonstrate the metric's value as a long term signal. However, the CAPE ratio does not predict short term market moves with any precision.
Shiller PE Ratio vs. Standard PE Ratio
Standard price to earnings ratios use a single year of earnings. This creates distortions. During a recession, earnings collapse and the PE ratio spikes, making stocks appear expensive even when prices have fallen. During a boom, inflated earnings make the PE ratio appear low, hiding potential overvaluation.
The CAPE ratio avoids these traps by using ten years of historical earnings. Robert Shiller showed that this approach produces a far more reliable picture of stock market valuation. The cyclically adjusted price to earnings metric captures the full range of business conditions rather than one snapshot. For long term investors, this makes the CAPE ratio a superior tool.
Using the CAPE Ratio to Forecast Future Returns
Research shows that high CAPE ratios tend to forecast future returns that are below average. When investors pay premium prices relative to historical earnings, subsequent ten-year returns tend to be lower. Low CAPE readings have historically predicted above-average returns over the following decade.
This does not mean the CAPE ratio can time the market in the short term. The stock market can remain expensive or cheap for years before reverting to normal levels. The metric works best as a long term planning tool. Investors who buy when the CAPE ratio is low and exercise patience when it is high tend to achieve better outcomes over full market cycles.
Limitations of the Shiller PE Ratio
The CAPE ratio has several limitations investors should understand. First, accounting standards have changed over the decades. Historical earnings may not be directly comparable to modern earnings. Changes in how companies report expenses and revenue affect the inflation adjusted earnings used in the calculation.
Second, low interest rates can justify higher price to earnings ratios. When bond yields are near zero, investors accept higher stock prices because alternatives offer minimal returns. The CAPE ratio does not adjust for the interest rate environment, which can make it appear elevated even when stocks are reasonably priced.
Third, the composition of the S&P index has shifted toward technology and services. These sectors tend to have higher profit margins than the manufacturing firms that dominated decades ago. This structural change may mean that the historical average is less relevant as a benchmark for today's stock market.
How to Apply the CAPE Ratio
Use the Shiller PE ratio as one input among several when evaluating the stock market. Combine it with other metrics such as the standard PE ratio, dividend yield, and the Buffett Indicator. When the CAPE ratio sits far above its long term average, consider reducing stock exposure or tilting toward undervalued international markets with lower ratios.
When the ratio drops well below average, it may signal a strong buying opportunity for patient long term investors. Robert Shiller himself cautions against using any single metric to make investment decisions. The CAPE ratio provides valuable context about where the stock market stands relative to its historical earnings but should never be the sole basis for action.
The Bottom Line
The Shiller PE ratio gives investors a powerful lens for evaluating the stock market. By using ten years of inflation adjusted earnings, the cyclically adjusted price to earnings metric avoids the distortions that plague standard price to earnings ratios. The CAPE ratio helps forecast future returns over long periods and has provided valuable warnings before major downturns like the dot com bubble. Use it alongside other valuation tools to build a complete picture of market health and make informed long term investment decisions.