The price/earnings ratio is probably the most widely used valuation ratio in investment, but it does have many flaws. In this video, Ed Bowsher looks at how the Shiller p/e ratio (also known as the cyclically adjusted p/e or Cape ratio) gets around these problems, and when it can be most useful in determining value.
How Does The Shiller P/E Or CAPE Ratio Work?
Hi. If you're a regular reader of Money magazine you may have noticed that we often talk about the Shilla P E ratio and we use it to see whether a particular stock market is overvalued or not. So I thought I'd do a video explaining how the ratio works and see what it tells us about markets right now. So should appeal to the P stands for price earnings ratio. We'll explain the price earnings ratio in previous videos. But just a really quick recap. It's just the normal price earnings ratio at his share price over earnings per share. Which is a measure of profits. If we do an imaginary company let's call it ABC. Share prices a pound earnings per share is ten P. We'll get a P E ratio of 10 that's the normal conventional P ratio of everything else being equal I'd say that company looks a bit cheap. Now the price earnings ratio has many defects and one of the big ones is that it doesn't take into account the economic cycle. So we're at the top of the economic cycle when times are good and we're in a boom you'd expect that earnings per share figure to move up say to twelve point five p and if the share price doesn't change suddenly the P falls to 8 pound twelve point five P divide them you get a P of 8. So the company looks cheaper but really nothing's changed the company hasn't got any more efficient hasn't become the underlying way more successful. All that's changed is the economy's got better. We're at the top of the economic cycle so an investor Benjamin Graham in the 30s who's one of the real investment greats he was aware of this problem. He said Lets average out those earning pished earnings per share figures over a period of five or ten years then calculate the P ratio with the average profits figure and that will give a better reflection of the underlying strength of the business. So that's great that's useful then in the 80s an economist called Robert Shiller came along he said let's take it another step forward. Let's also take into account inflation. So if we're looking at this company ABC let's also think about inflation. So this let's say because when let's imagine we're at the top of the economic cycle last year yeah the earnings per share was 12 and a half the year before was 10p 10 years ago. The guess was four point nine years ago it was5.5 P. And obviously you've got other figures in between.
So Benjamin Graham would just add up all these different earnings figures all 10 an average them out which Shiller says no let's adjust for inflation so let's say there's been 40 percent inflation over the last 10 years said that moves the EPA figure to five point six P. Let's say that was 30 percent inflation over the last nine years. Got any gasify here that gives us an inflation adjusted figure of six and a half p and so on. We then average out those inflation those inflation adjusted numbers let's say the average is a P put the share price over and we have a Shilla P E of twelve point five.
That has better reflects the true strength of the company than just the normal P E ratio. It's looking at all the earnings over the last 10 years and giving us an average which tells the strength of the company. Now as I said a minute to.