CAPE, or CAPE ratio

The CAPE ratio, or cyclically adjusted price-to-earnings ratio, also known as the Shiller price-to-earnings (p/e) ratio (made popular by economist Robert J. Shiller), is used to see whether a stock, a share market, or index — like the S&P 500 — is overvalued or undervalued. For a stock, the CAPE ratio uses the average of a company's earnings over the past 10 or 20 years, adjusted for inflation. By doing this, it smooths out short-term volatility (movements up and down) so is a stable measure of earnings. By adjusting for inflation, the CAPE ratio shows the changes in the purchasing power of money over time (making it a truer reflection of real earnings). 

A high CAPE ratio may mean that the stock (or market, or index) may be overvalued (and may be at risk of a crash), while a low CAPE ratio indicates potential undervaluation (and could mean a future positive performance). 10 or lower is a low CAPE ratio, 16 is the median CAPE ratio, and 25 or above is high. For example, the S&P 500’s CAPE ratio may be used by some analysts as a possible indicator of a market crash, while others maintain CAPE cannot predict future performance. 

CAPE ratio formula:

Example: If a stock is US$100 and the average inflation-adjusted earnings over the past 10 years is US$5, the CAPE ratio would be 20, meaning that the stock is trading at 20 times its average earnings over the past decade. Using the CAPE ratio, this means it may be overvalued.