The Shiller P/E (price to earnings) ratio is one of our favorite fundamental valuation metrics. Unlike technical indicators, which are typically based only on stock prices and volumes, fundamental metrics take into account actual data from the company associated with the security, such as corporate revenues, earnings, assets, etc. Many investors feel that over time, the price of a security will eventually become closely linked to the underlying financial health of the company associated with it, although significant deviations are certainly possible. The Shiller P/E Ratio is a powerful metric to analyze the health of the stock market as a whole, based on some fundamental data of the companies comprising the market. Read on for more details…
Basic P/E Ratio
A basic P/E (price to earnings) ratio simply takes the price of a security and divides it by the earnings (profits) per share of the last four quarters of the company associated with the security. This is referred to as a trailing P/E, or typically just the P/E. A variant of this can be created by using projected earnings per share, called a leading P/E.
The P/E thus represents how much profit (or loss!) of a company an investor is paying for with for each share of the company purchased. As a result, the P/E ratio can be used to relatively easily compare the prices of shares of various companies.
The Shiller P/E Ratio
The Shiller P/E ratio is a variant of the basic P/E ratio and is also known as the cyclically adjusted price-to-earnings (CAPE) ratio, or P/E 10 ratio. It was created by the Nobel Prize winning economist Robert J. Shiller of Yale University.
The Shiller P/E ratio is calculated by taking the price of an asset or index and dividing it by the average of the last ten years of earnings (profits) per share, where the profits over these ten years are adjusted for inflation to make them comparable to one another. The ten year term is picked as it best represents the duration of a typical business cycle.
A high value of the Shiller P/E ratio generally indicates that a company or a market is relatively expensive and that investors may experience lower than average returns going forward, whereas a low value indicates that a company or a market is relatively cheap and that investors may experience higher than average returns going forward.
The plot below shows the current US S&P 500 Index Shiller P/E ratio as of September 11, 2014. The value is calculated as 26.43. For reference, the mean of the ratio is 16.55 and the median is 15.93 based on over 120 years of data.
Source: www.multpl.com/shiller-pe/
While the current value is certainly higher than the mean and median over the past 120 years or so, it is not necessarily an immediate cause for alarm. Although the ratio can signal if the markets are relatively expensive or cheap based on their long term average, it cannot predict at what point they will revert to that average, or how extensive the trend would be. It also does not predict if the markets will become even more expensive. Using the Shiller P/E ratio, one can see from the plot above that the markets are not nearly as expensive as they were at their highs in 2008 prior to the recent recession.
The Shiller P/E ratio is only one tool to analyze the markets, and it cannot be viewed in isolation of other methods. Future articles will discuss these other methods.