What Is the P/E 10 Ratio?
Let me explain the P/E 10 ratio directly to you—it's a valuation indicator I often see used with major equity indexes, and it factors in real per-share earnings over a 10-year period. You might also hear it called the cyclically adjusted price earnings ratio.
In essence, the P/E 10 is a long-term valuation metric that gets applied to stock indexes, and it's calculated using inflation-adjusted earnings per share averaged over the past decade. What it does is use smoothed real earnings to cut out the fluctuations in net income that come from variations in profit margins during a typical business cycle. I should note that the P/E 10 ratio is also known as the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio.
Key Takeaways
- The P/E 10 ratio is a valuation measure for equities that uses real per-share earnings over 10 years.
- The P/E 10 ratio also uses smoothed real earnings to eliminate net income fluctuations.
- The P/E 10 ratio is also known as the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio.
Understanding the P/E 10 Ratio
You should know that this ratio was popularized by Yale University professor Robert Shiller, who wrote the bestseller 'Irrational Exuberance' and won the Nobel Prize in Economic Sciences in 2013. Shiller got a lot of attention when he warned that the wild U.S. stock market rally in the late 1990s was going to end up as a bubble.
The P/E 10 ratio draws from the work of renowned investors Benjamin Graham and David Dodd in their 1934 book 'Security Analysis.' They pointed out that illogical P/E ratios often stem from temporary and sometimes extreme swings in the business cycle. To handle that, Graham and Dodd suggested using a multi-year average of earnings per share—say, five, seven, or 10 years—when you're figuring out P/E ratios.
How to Calculate the P/E 10 Ratio
Here's how you calculate the P/E 10 ratio: start by taking the annual EPS of an equity index like the S&P 500 for the past 10 years. Adjust those earnings for inflation with the consumer price index (CPI), meaning you bring past earnings up to today's dollars. Then, average those real EPS figures over the 10 years. Finally, divide the current level of the S&P 500 by that 10-year average EPS to get the P/E 10 ratio or CAPE ratio.
I've seen that the P/E 10 ratio can vary quite a bit over time. Based on data from 'Irrational Exuberance'—released in March 2000 right at the dotcom boom peak—and updated through August 2020, it ranged from a low of 4.78 in December 1920 to a high of 44.20 in December 1999. As of August 2020, the historic average was 17.1.
Using market data from estimated earnings (1881 to 1956) and actual reports (1957 onward) from the S&P index, Shiller and John Campbell found that a lower CAPE means higher likely returns for investors in equities over the next 20 years.
Shortfalls of the P/E 10 Ratio
One criticism you'll hear about the P/E 10 ratio is that it's not always spot-on for signaling market tops or bottoms. For instance, an article in the September 2011 issue of the American Association of Individual Investors Journal pointed out that the CAPE ratio for the S&P 500 was 23.35 in July 2011.
If you compare that to the long-term CAPE average of 16.41, it suggests the index was over 40% overvalued then. The article argued that the CAPE gave an overly bearish take on the market, especially since standard valuation measures like the regular P/E showed the S&P 500 at a multiple of 16.17 (on reported earnings) or 14.84 (on operating earnings). Sure, the S&P 500 dropped 16% in one month from mid-July to mid-August 2011, but it then climbed more than 35% from July 2011 to new highs by November 2013.
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