All you need to know about the Shiller PE ratio

Shiller PE Cape Ratio Chart

Investing can be complicated, and many different approaches aim to simplify the process. The Shiller PE ratio’s goal is to provide additional data for investors regarding a company’s stocks. However, it is also a useful tool for seeing the strength of the overall U.S. stock market.

What is the Shiller PE ratio?

The Shiller PE ratio measures broad equity indices using actual per-share earnings over a 10-year period. It is a metric that can measure the price of a stock compared to the profits a company makes per share. The aim is to identify fluctuations that occur in different business cycles. The ratio is able to give a market value rating without being influenced by regular business cycle fluctuations. Ultimately, the Shiller PE ratio should be able to determine if a company is overvalued or undervalued.

It's crucial not to confuse the Shiller PE ratio with the PE ratio, which does not account for business cycle fluctuations and is a less reliable measure of the market. One of the most significant differences between the ratios is that the PE ratio uses 12-month earnings.

Also known as the cyclically adjusted price-to-earnings ratio, it was a formula promoted by Professor Robert Shiller from Yale. He suggested that inflation-adjusted, 10-year earnings data would result in more accurate calculations.

Shiller has written a book that gathers the PE ratios for the U.S. stock market going as far back as 1871.

What is the PE Ratio formula?

The formula to calculate the Shiller PE ratio is the share price divided by investment income over 10 years. It looks like this:

PE Ratio = share price / 10-year avg, inflation - adjusted earnings

To complete the calculation, you’ll need to gather data on an index’s earnings per share over the past 10 years. Next, you’ll need to make adjustments for inflation that will bring the numbers to more current ones. Then you find the average. Finally, take stock’s current price and divide the average you’ve calculated.

How do you use the PE ratio?

The main reason for using the forecasting of the PE ratio is to determine a company’s profits and how well the organization is doing. It can also help to determine where in the cycle a business is. Having this information can help investors make better choices when it comes to long-term investing options. For example, if a company is undervalued according to the PE ratio, it could be a good time to buy and prepare for higher returns in the future.

The Shiller PE ratio also takes the temperature of the overall stock market to determine if it is overvalued or undervalued. The higher the ratio, the more overvalued the market is.

If a market is calculated to be overvalued, according to the Shiller PE ratio, it could signify a market correction is coming. This can also be a sign that a recession is on the horizon.

In the end, the Shiller PE ratio should be seen as one tool that investors can use to gauge the stock market before diving in. However, you won’t need to gather the data and calculate the ratio on your own. There are many places you can find the Shiller PE ratio online. It’s recommended to use more than one method when you make investment decisions.

Accuracy of the Shiller PE ratio

Some have questioned the accuracy of the Shiller PE ratio, and it is not always accurate when measuring. However, one researcher found that the Shiller PE ratio has historically been “consistently good at predicting bear markets.” Using advanced technology, they were able to test data and compare it with Shiller PE ratio results. Looking back at the Shiller PE results and what happened in the market, the ratio has proven that it can successfully forecast market movements.

Another analysis of historical market activity has found that the Shiller PE ratio is reliable for predicting long-term returns on the stock market. However, it’s important not to make your investment decisions on one tool. Moreover, if you’re looking for short-term gains, the Shiller PE ratio won’t be useful because it focuses on 10-year returns.

Limitations of the Shiller PE ratio

Not everyone is a fan of the Shiller PE ratio. Some have even called it useless and backward-looking. They claim it does not account for changes that can happen in the future.

Another criticism of the PE ratio is that it was built on generally accepted accounting principles or GAAP, which have changed over the years. It has been argued that the Shiller PE ratio could be too pessimistic because of the GAAP.

Some have suggested switching from GAAP earnings to using other data like operating earnings or national income and product account or NIPA. Doing this may improve the forecasting of the PE ratio.

The Shiller PE ratio is unable to account for changes to a business’s earnings that are a result of things like recessions or industry changes.

According to Forbes, Shiller has recently made a proposal for a new calculation. He did this to account for changes in corporate payouts. In some cases, organizations are more likely to go for share repurchases over dividends for shareholders. This practice can impact the accuracy of the PE calculation. As a result, Shiller recommends “a total return CAPE that reinvests dividends into the price index,” the Forbes report stated.

Conclusion

While the Shiller PE ratio has proven to be accurate more often than not, it’s important to consider other elements when it comes to investing. Consider the company’s earning’s record alongside ratios and data like the Shiller PE ratio. And always look to invest more when the market reads undervalued. That way, you’ll be able to buy stocks at a low price and wait for a high return.

See also: The Buffett Indicator and our unique U.S. stock market valuation chart.