Understanding CAPE Ratio: Indian Stock Market

Investing in the stock market can be confusing and complicated. Seasoned investors use tools to understand the market breadth. Among the many tools, market valuation metrics guide decisions most effectively. It helps the investors identify whether a market or a specific stock is overvalued or undervalued. One such powerful metric is the Cyclically Adjusted Price-to-Earnings (CAPE) ratio.CAPE Ratio is developed by Nobel laureate Robert Shiller. The ratio provides a long-term perspective on inflation-adjusted market valuations.As we delve into the intricacies of the CAPE ratio, we will discover how this metric can help us gauge future market returns. Trained investors use the CAPE ratio as their yardstick to judge asset allocation.Topics:1. Introduction to CAPECAPE ratio, sometimes called the Shiller P/E ratio, is a measure that smooths out short-term fluctuations in earnings. The earnings are adjusted for inflation to give a more consistent view of a market’s valuation over time. This metric is Robert Shiller’s way of predicting future market returns with greater accuracy.The CAPE ratio takes the average of a company’s real earnings over the past ten years and divides it by the current share price. What are real earnings? It is the reported earnings (nominal earnings) adjusted for inflation. We’ll see later in this article the inflation adjustment is done.By focusing on a longer time frame, the CAPE ratio mitigates the impact of short-term economic cycles. and temporary business fluctuations. This way it provides a clearer picture of the market’s true value.CAPE ratio is generally used to value the overall market but it can also be used for specific stocks.The significance of the CAPE ratio lies in its ability to offer a more stable measure of market valuation. Traditional P/E ratios are more volatile, influenced by short-term earnings spikes or drops. Such volatile P/E may not accurately reflect the long-term potential of a market. The CAPE ratio, with its emphasis on long-term earnings, allows investors to see beyond the noise. This way it helps us to identify whether a market is fundamentally overvalued or undervalued.1.1 Purpose of the PostThe CAPE ratio has been extensively studied and applied in developed markets like the US. But I think, its relevance and application in emerging markets like India are less explored. Through this blog post, my aim is to bridge that gap by examining how the CAPE ratio can be used to understand market valuations.By analyzing the CAPE ratio for a major Indian index (Sensex), my aim is to shed light on its implications for future market returns. For individual investors, understanding the CAPE ratio can provide valuable insights into when to enter or exit the market. This way, we can thereby enhance our long-term investment strategies.Let’s try to learn about the CAPE ratio by building a comprehensive understanding of its concepts.2. What is The CAPE RatioCAPE ratio is an acronym for Cyclically Adjusted Price-to-Earnings ratio. It is a valuation measure that adjusts for inflation and averages earnings over a ten-year period. It is done to smooth out the earning fluctuations caused by economic cycles.The CAPE ratio provides a long-term perspective on market valuations. This approach minimizes the impact of short-term volatility. Hence, it offers a more stable and reliable indicator of whether a market is overvalued or undervalued. A deeper understanding and usage of the CAPE ratio can help us make more calculated market calls which will be based on long-term trends rather than short-term market movements.2.1 Calculation of CAPE RatioCalculating the CAPE ratio involves several steps. It is primarily focused on adjusting earnings for inflation and averaging them over a long period. Here’s a step-by-step explanation using a hypothetical example:Gather Earnings Data: First, collect the annual earnings (net profit) data for a company or market index for at least the past ten years. For instance, let’s assume we have the following inflation-adjusted annual earnings per share (EPS) for a company over the past ten years: 5, 6, 7, 8, 9, 10, 11, 12, 13, and 14.Inflation Adjustment: To adjust nominal earnings for inflation, convert the earnings from past years into present-day values using an inflation index (CPI). For example, if a company had nominal earnings (EPS) of Rs.50 in 2010 and the CPI in 2010 was 100. Also, assume that the CPI in 2024 is 120. We can adjust the 2010 earnings to 2024 by multiplying Rs.50 by the ratio of the 2024 CPI to the 2010 CPI (120/100). The result will be Rs.60. This adjusted figure reflects the EPS in terms of current purchasing power, allowing for more accurate comparisons across different years.Calculate the Average Real Earnings: Add the inflation-adjusted earnings for each of the past ten years and divide by ten to find the average. Using our example, the sum of the earnings is 95 (=5+6+7+8+9+10+11+12+13+14). Dividing this by ten gives an average real earnings per share of 9.5.Note the Current Share Price: Find the current share price of the company (or Index) or the current level of the market index. Suppose the current share price is 190.Calculate the CAPE Ratio: Divide the current share price by the average real earnings to get the CAPE ratio. Using our example, the CAPE ratio would be 20 (=190/9.5), which equals 20.Thus, the CAPE ratio for this hypothetical company (index) is 20. What does it mean? It indicates that investors are willing to pay 20 times the average earnings over the past decade, adjusted for inflation.As a stock analyst, it will be interesting to see the difference in values between the P/E and CAPE ratios.3. How CAPE is Different From P/E RatioThe CAPE ratio and the traditional Price-to-Earnings (P/E) ratio are both tools used to evaluate stock market valuations. However, they differ significantly in their calculation methods and the insights they provide.The P/E ratio is calculated by dividing the current share price by the earnings per share (EPS) over the most recent 12-month period. It provides a snapshot of what investors are willing to pay today for a dollar of current earnings. However, the P/E ratio can be highly volatile as it is sensitive to short-term fluctuations in earnings. The P/E ratio is influenced by temporary factors such as market cycles, seasonal trends, or one-time events. This makes the P/E ratio potentially misleading during periods of economic instability or rapid changes in corporate earnings.The CAPE ratio takes a longer-term view by averaging inflation-adjusted earnings over the past ten years. This smoothing process helps to mitigate the effects of economic cycles and temporary anomalies. Hence, it provides a more stable and reliable measure of market valuation. By adjusting for inflation, the CAPE ratio ensures that the earnings used in the calculation reflect real purchasing power, allowing for more meaningful comparisons across different time periods.ExampleConsider a company that experienced a significant earnings spike due to a one-time event, such as a major asset sale. The P/E ratio for that year would be artificially low, suggesting that the stock is undervalued. However, the CAPE ratio, by averaging earnings over ten years, would moderate the impact of this spike. This way it will give a truer picture of the company’s valuation.The CAPE ratio is a more contrarian-investor-friendly indicator. How? Historical data suggests that higher CAPE values tend to be associated with lower future returns, and vice versa. This is because the CAPE ratio helps to identify periods when the market may be overvalued or undervalued.4. Importance of CAPE RatioThe CAPE ratio is regarded as a superior predictor of future market returns. Why? Because of its ability to smooth out short-term volatility. This way it provides a more accurate measure of long-term market valuations.Here are the following reasons why the CAPE ratio is so valuable for investors:Mitigating Short-Term Fluctuations: Unlike the traditional P/E ratio, which can be skewed by short-term earnings fluctuations, the CAPE ratio averages earnings over ten years. This long-term perspective helps to eliminate the noise caused by economic cycles, seasonal variations, and one-time events, offering a clearer view of a company’s or market’s true earning power.Adjusting for Inflation: By adjusting past earnings for inflation, the CAPE ratio ensures that the earnings data used in its calculation reflect real purchasing power. This adjustment allows for more meaningful comparisons across different periods, making the CAPE ratio a more reliable measure of valuation.Historical Predictive Power: Empirical research, particularly in developed markets like the US, has shown that the CAPE ratio is inversely related to future market returns. Higher CAPE ratios have historically been associated with lower future returns, while lower CAPE ratios have been linked to higher future returns. This inverse relationship makes the CAPE ratio a valuable tool for predicting long-term market performance.Guiding Investment Decisions: The CAPE ratio can inform various aspects of investment strategy. For example, it can help investors identify periods when the market is overvalued or undervalued, guiding decisions on when to buy or sell. It also aids in asset allocation, as investors can adjust their portfolio weights based on market valuation insights provided by the CAPE ratio.Behavioral Insights: The CAPE ratio also reflects investor sentiment and market psychology. During periods of high CAPE values, there is often excessive optimism and overvaluation, while low CAPE values may indicate pessimism and undervaluation. Understanding these behavioral patterns can help investors make more rational decisions, avoiding the pitfalls of herd mentality.In the context of the Indian stock market, applying the CAPE ratio can provide investors with valuable insights that go beyond traditional metrics. By focusing on long-term earnings and adjusting for inflation, the CAPE ratio helps investors see the bigger picture, making it a crucial tool for those looking to make informed, strategic investment decisions.5. CAPE Ratio of SensexHere is the last 10-year Sensex data and its related EPS and the corresponding Inflation data. I’ll show, how to calculate the CAPE Ratio for the year 2024.YearSensexNominal / Reported EPSInflationReal EPS10-Yr Average of Real EPSCAPE Ratio202480,502.083,303.334.80%3144.771838.5343.79202372,240.262,897.725.70%2732.55– –202260,840.742,575.816.70%2403.23– –202158,253.822,144.055.13%2034.06– –202047,751.331,457.176.62%1360.71– –201941,253.741,475.983.73%1420.93– –201836,068.331,534.823.94%1474.35– –201734,056.831,380.503.33%1334.53– –201626,626.461,295.064.95%1230.95– –201526,117.541,313.764.91%1249.25– –Here are the steps:Create a table in Excel with the following columns: Year, Sensex, Nominal-EPS, Inflation, Real-EPS.Input the Sensex data, EPS data, and Inflation data for the past 10 years.In the Real EPS column, enter the formula =C2*(1-D2). This formula calculates the real (inflation-adjusted) EPS for each year by multiplying the EPS by (1 – inflation).Add another column “F” to the table. Name it “10-Yr Average of Real EPS.” Use this formula =AVERAGE(E2:E11)to calculate the average real EPS over the past 10 years. You can see in the above table, that the calculated value is 1838.53.Now, we are ready to calculate the CAPE Ratio of Sensex for the Year 2024. In another cell, enter the formula = Sensex for 2024 / 10-Yr Average of Real EPS. Using this formula, the CAPE Ratio will be 43.79.P/E Vs. CAPE Ratio of Sensex Between Years 2009 and 2024Using the above method, I’ve calculated the CAPE Ratio of Sensex between years 2009 and 2024. For this, I’ve used the available Sensex data from year 1998 to 2024. I’ve also plotted the P/E and CAPE Ratio of Sensex in a Chart to get a perspective.What can we learn from these values and charts?The P/E ratio and the CAPE ratio are two important metrics we can use to evaluate the valuation of an index like the Sensex. Let’s see how they can be used to judge market valuations.General Observations from the Sensex Data (2009-2024)Over the years, both the P/E and CAPE ratios have fluctuated, reflecting the market’s changing valuations. There are periods when both ratios are high, suggesting overvaluation, and periods when they are low, indicating undervaluation.CAPE Ratio Peaks and Corresponding P/E RatioMonthsP/E PeaksCAPE PeaksRemarksSep-1022.9943.67Rally after the crash of 2008-09Nov-1419.2136.87Rally After Modi as PMAug-1824.4936.61CAPS Peaking and staying there till 2020Dec-1927.9535.82Just Before the COVID CrashSep-2130.6246.5Rally After COVID CrashJul-2424.3747.7Today (July 2024)CAPE Ratio Lows and Corresponding P/E RatioYearP/ECAPERemarksMar-200912.6825.10Bottom of 2008-09 CrashMay-201216.4928.52First correction after 2008-09Feb-201617.4826.06Post correction After Modi first became PM in 2024Mar-202019.5525.18Bottom of COVID CrashJun-202221.7938.99First correction after Post-Covid RallyMarket ValuationsCurrent Values: As of Jul 2024, the P/E ratio is 24.37 and the CAPE ratio is 47.70. Both ratios are relatively high compared to historical lows, suggesting that the market may be overvalued at this point.Long-Term Perspective with CAPE: The CAPE ratio provides a broader view by averaging earnings over 10 years. Which in turn helps in understanding the market’s long-term trends. High CAPE values have historically preceded market corrections. Similarly, low CAPE values have often indicated buying opportunities.Short-Term Perspective with P/E: The P/E ratio reflects more immediate market conditions and investor sentiment. It can be useful for short-term decisions but might be more volatile compared to the CAPE ratio. It is advisable to use the CAPE Ratio (over P/E) ratio to build a long-term perspective of the market valuations.6. Use of CAPE Ratio – Its UtilityHere’s how we stock investors can use the CAPE ratio for analysis of an index like Sensex:Identifying Overvaluation/Undervaluation: We can use the CAPE ratio to determine if the Sensex is overvalued or undervalued. A high CAPE ratio (above 25-30) indicates overvaluation. A low ratio (below 15-20) suggests undervaluation.Long-term Market Timing: By analyzing the CAPE ratio’s historical trends, we can identify potential long-term market tops and bottoms. For example, the CAPE ratio of Sensex was significantly high in 2010 (at 43.67) than its historical average. It was a sign of a market peak and hence the index majorly corrected after that.Comparing Valuations Across Time: We can use the CAPE ratio to compare the Sensex’s current valuation to its past valuations. This helps identify whether the market is more or less expensive than it was in the past. See the CAPE and PE trends shown in the chart shown above from 2009 to 2024.Relative Valuation: The CAPE ratio can be used to compare the Sensex’s valuation to other global indices, such as the S&P 500. This helps investors identify potential opportunities or risks in the Indian market relative to others.Reference To Mean Levels: Investors can expect the CAPE ratio to revert to its historical mean over time. If the ratio is currently high or low, it may be expected to move towards its mean, providing a potential investment opportunity.Combining with Other Metrics: The CAPE ratio can be used in conjunction with other metrics, such as dividend yields or price-to-book ratios, to form a more comprehensive view of the market’s valuation.7. Use of CAPE Ratio Over P/E RatioReferring to the CAPE ratio instead of the P/E ratio (TTM) provides a more comprehensive understanding of market valuation. How? The CAPE ratio takes into account the market’s earnings over a longer period, typically 10 years, and adjusts for inflation. This allows for a smoother earnings figure, reducing the impact of short-term market fluctuations and business cycles.In contrast, the P/E ratio (TTM) is based on Trailing Twelve Months’ earnings, only considers the market’s earnings over the past year. This can lead to distorted valuations, as short-term earnings can be influenced by various other factors. These factors could be like economic cycles, one-time events, or accounting changes.By using the CAPE ratio, investors can gain a better understanding of the market’s true valuation. CAPE Ratio provides a more stable and long-term perspective. Additionally, the CAPE ratio’s inflation adjustment ensures that the valuation is measured in real terms, rather than being skewed by inflationary effects. ‎ConclusionUnderstanding the CAPE Ratio offers valuable insights for investors looking to gauge market valuations.By using the long-term CAPE Ratio and P/E Ratio as a metric, we can discern long-term market trends.The CAPE Ratio’s emphasis on cyclically adjusted earnings provides a clearer picture of market value, especially during volatile periods.Using this tool alongside other indicators can help investors maintain a balanced perspective on market conditions, ultimately aiding in more strategic, long-term investment planning.Suggested Reading: