The Shiller P/E ratio is a measure often applied to the US equity market.
Invented by Professor Robert Shiller of Yale University, it is a specific metric that helps investors figure out if a market or company is overvalued or undervalued.
The Schiller P/E ratio is a type of P/E ratio, so why don’t we tackle that first.
What is a P/E ratio?
A P/E ratio simply stands for the Price to Earnings ratio. You take the price of a stock and divide it by the earnings per share to get some idea of whether a company is expensive or cheap.
For example, what is the P/E ratio of Apple?
Currently a single share of Apple stock trades at about $130. The earnings per share (EPS) is $8.35. Divide one by the other and that gives us a P/E ratio of 15.3.
What does 15.3 mean, in this context? That multiple tells us that if you were to buy a share of Apple right now, you’d be paying 15 times the earnings per share for the privilege. Think of it like the price tag of a stock.
The P/E ratio is often used as a point of comparison. The ratio for the broad U.S. stock market is about 26, and all things being equal, it indicates that the overall market is more expensive than a share of Apple alone. You might compare Apple’s P/E ratio to itself, over time, to see whether Apple is cheaper than it has been in the past, or you could compare it to other similar, tech companies to see how the iPhone-making giant stacks up.
What is a Shiller P/E ratio?
Take a second to think about what the P/E ratio is. We took the price of a single stock and divided it by the earnings per share.
Typically, the earnings per share (EPS) value uses the earnings over a period of twelve-months. A P/E ratio constructed this way would be called the trailing-twelve month P/E ratio. So if you divided the current share price by the previous year’s EPS then you are getting a sense of how expensive a stock is, in relation to its earnings for the year.
But people like to get creative, and they use all sorts of time-frames for the EPS.
What Shiller did, was extend the time period to 10 years.
Why is it useful?
This chart below shows us the traditional P/E ratio and plots it against the return of the overall U.S. market for the next 12 months.
The scattershot nature of the graph tells us that the traditional P/E ratio doesn’t have any ability to forecast the return of the U.S. equity market.
Shiller found that by going to the 10-year P/E ratio, he was better able to forecast future stock market returns.
As you can see, there’s a much clearer trend there. The higher the Shiller P/E (CAPE is just another name for it), the lower the return of the market over the next 10-15 years.
The idea is that by looking at earnings over 10 years, you’re able to smooth out any weird fluctuations and get a clearer picture of where the economy is headed because very long-term earnings are correlated with future stock market returns.
Although the Shiller P/E ratio can be an effective tool, it shouldn’t be abused.
This ratio is a good indicator to look at, but it’s important to remember that most investors, analysts and market professionals will not base their decisions to buy and sell on the Shiller P/E ratio alone.