P/E Ratio is one of the simplest valuation multiples and that is also its main shortcoming. The ratio of current price to recent last four quarters earnings is a simple but very effective tool to evaluate a stock, portfolio or market since the beginning of the stock market. The lower the PE, the less you are paying for future earnings. It’s quick and easy, hence popular. The criticism for P/E ratio is that it doesn’t account for the cyclical nature of a business or the different phases of the business cycle. Thus, P/E ratio can’t be extrapolated as price and earning of one era can’t be compared with price and earning of a different era.

The famous value investors Benjamin Graham and David Dodd, in the early 1930s in the book Security Analysis, argued that a single year’s earnings would be too volatile to evaluate a company’s real value in the marketplace. To control for cyclical effects, Graham and Dodd recommended dividing price by a multi-year average of earnings and suggested periods of five, seven or ten years. Based on that idea, Robert J. Shiller and John Y. Campbell in 1998 developed a cyclically adjusted price-to-earnings ratio (CAPE), which puts the current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year observation period is to ensure that the profits are averaged over more than one earnings cycle. Shiller and Campbell’s research found a negative correlation between the CAPE ratio and the stock market performance over the next ten years. A high current CAPE ratio meant poor future stock returns.

The cyclically-adjusted price-to-earnings (CAPE) ratio of a stock market is one of the standard metrics used to evaluate whether a market is overvalued, undervalued, or fairly-valued. This metric was popularized during the Dotcom Bubble when Robert Shiller, a Yale University Professor of Economics and Noble Prize winner, correctly argued that equities were highly overvalued.  For that reason, it’s also referred to as the “Shiller PE”, meaning the Shiller variant of the typical price-to-earnings (P/E) ratio of stock.

Does the Shiller PE predict the future returns? In his book “Irrational Exuberance,” Shiller shows that CAPE is correlated to the subsequent 20-year annualized return after inflation. A low P/E bodes well for the next 20 years of investing, whereas a higher ‘PE 10’ suggests a lower expected return.

The GuruFocus.com has a nice article on Shiller PE – A Better Measurement of Market Valuation in which they write:

If we assume that over the long term, the Shiller PE of the market will reverse to its historical mean of $mean, the future market return will come from three parts:

1. Contraction or expansion of the Schiller P/E to the historical mean
2. Dividends
3. Business growth

The investment return is thus equal to:

We don’t have much Sensex data prior to 1990 hence can’t compare our finding with the US data. Still, the above graph shows a remarkable correlation close to 80% between implied return and the actual 3 years return. For calculation, the business growth is taken as average annual GDP growth since 2000. We believe the real earning growth of composite or large-cap index tends to align with GDP growth over long-term.

Despite its value in projecting future returns over long periods of time, the Shiller PE is often misused when applied to any periods other than long ones. The elevated Shiller PE is in no way an indication that investors should sell their equities. In reality, the Shiller PE has almost no predictive value in determining where the market will go in the next year or other shorter term periods. We must emphasize the fact that valuation metrics are not a market timing tools.

In terms of shortcomings, Shiller PE is based on the false premise that earnings can be normalized using inflation only. Population growth, productivity growth, interest rates, and dividend payout ratios are all key ingredients in earnings growth and they are neglected by this ratio.

No valuation ratio is ever going to explain the market fullest. Every multiple has some positives and some negatives but the Cyclically Adjusted Price-to-Earnings ratio or “CAPE” has shown remarkable ability at least in the US market for assessing long-term future returns. However there are situations when the earnings growth is higher for reasons other than inflation, Shiller PE may give a false reading, and it will show much higher value than the reality.