Cyclically Adjusted Price to Earnings (CAPE) Ratio - A VALUATION TOOL FOR DSEX

Cyclically Adjusted Price to Earnings (CAPE) Ratio – A VALUATION TOOL FOR DSEX

  • By akramul

  • 30 Mar, 2020

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The Cyclically Adjusted Price to Earnings (CAPE) Ratio (commonly known as the Shiller P/E multiple): What does it mean to us?

Originally popularized by Yale University professor Robert Shiller, the CAPE ratio is a cyclically adjusted price-to-earnings (P/E) ratio. In comparison to a traditional P/E ratio, the CAPE ratio uses Real Earnings per Share (inflation-adjusted EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. It is also known as the Shiller P/E multiple. Generally, a P/E multiple is a valuation tool that can be used to find a stock’s price relative to the company’s EPS; where EPS is a company’s Net Profit per unit of common shares outstanding. While the traditional P/E multiple uses EPS based on normal reported earnings, the CAPE ratio uses Real EPS by based on inflation-adjusted earnings.

Instead of an individual stock, the CAPE ratio is generally applied to broad equity indices (e.g., DSEX) to assess whether the market is undervalued or overvalued. While the CAPE ratio is a popular and widely-followed measure, several leading industry practitioners have called into question its utility as a predictor of future stock market returns.

Formula of CAPE:

Cyclically Adjusted Price to Earnings (CAPE) Ratio Formula

When calculating the CAPE or Shiller P/E ratio for a whole index, market price per share is replaced by Market Capitalization of all the listed securities and the 10-year inflation adjusted EPS is replaced by aggregate 10-year inflation adjusted earnings of all the listed securities over same time horizon.

What does CAPE ratio tell about?

A company’s profitability is determined to a significant manner by the economy’s business cycle. During boom, profits rise as there is more consumers spending, while during recessions, spending falls, profits drops, and losses could emerge. While profit swings are much larger for companies in cyclical industries, i.e. commodities, banking/finance etc. than they are for entities in conservative industries i.e. energy, pharmaceuticals etc., few companies can maintain consistent profitability trend over time. If investors want to adjust good and bad times in an economy under their investment appraisal process, they should consider companies’ inflation-adjusted earnings over ideally 7 to 10 years to compute the P/E since inflation adjustments could capture the business cycle movement. Investors can use this approach to compare the true valuation of their investment or the market as a whole with what is actually observed, which in turn would indicate whether their investment or the broad market index overall is overvalued or undervalued.

How does the CAPE ratio look like for Dhaka Stock Exchange?

Shiller P/E multiple of DSE bourse
Between FY2007 to 2019, the CAPE or Shiller P/E ratio of the Dhaka Stock Exchange plots a true reflection of the business cycle over a 13 years’ timeline that includes a bubble and a bust!

The chart above shows that a peak in FY2010 is suggested where the CAPE ratio stood the highest (a Shiller P/E of 108.3) suggesting a red signal for the investors. Surprisingly the ratio dropped from 108.3 to 51 (by a half) between FY2010-11 as the bubble went burst. The long-term 13-year average of Shiller P/E for DSEX stands at 43.5, which can be used to evaluate the market valuation. From FY2007 to 2010, a higher than average (53 to 57) was triggered by hyper demand for stocks; it indicates that the market was broadly overvalued during that period, which even stretched out until 2011 (51 Shiller P/E).

In the post stock market crash period, the CAPE ratio started to fall gradually from 51 to 17 between FY2011 to 2019. The Shiller P/E multiple of FY2019 (17) stood 13-year low, suggesting a good time for value investors to generate portfolio alpha! In the coming days, the fast-growing economy of Bangladesh is likely to see a bullish cycle, which eventually opens opportunities to the investors despite the ongoing crisis of coronavirus (COVID 19) impacts on the global markets. The risk however is subject to the timing and ability of controlling the outbreak.

Histogram of Shiller P/E

Benchmarking the CAPE ratio

The existence of high-values of Shiller P/E in different years challenges the accuracy or relevance of the simple average method for benchmarking purpose. As an alternative approach, an ‘uppercut’ can be deployed in computing the benchmark CAPE ratio. To wipe out the influences of very high values, in this approach, simple average of the historic P/E values is calculated excluding values of 40 or above, which is then used as the benchmark Shiller P/E. The uppercut value for DSE is determined in line with the local compliance rule that tells 40 or higher P/E is non-marginable and hence risky for investment.

 

The following table illustrates the benchmarking:
Understanding the benchmark Shiller P/E level
The Benchmark Shiller P/E of DSE stands at 26.9, and the fair index value should be at 7032.96 points or nearby, ceteris paribus. It supports our earlier comment that the market is currently undervalued with a broad return potential of about 58%.

What critics tell about the Shiller P/E multiple or CAPE ratio?

Several criticisms are available on the use of the Shiller P/E or CAPE ratio that investors should be aware of:

  • Most businesses have changed today than they were 10 years ago in all areas of operation including operations, supply chain, regulatory framework and most importantly technology. Such as many retail businesses have now entirely changed from even 5 years ago.
  • Financial reporting frameworks over time changes with the advancement of time.
  • P/E ratios are higher today in part because interest rates are on a 40-year downtrend that pushes down the cost of debt. At lower interest rates of the deposit schemes in banks, stocks become attractive to the investors.
  • The first rule of economics is price is a function of supply and demand. Demand and supply of equities in DSE follows dramatic changes over time. For example, over the past ten years, market demand has substantially increased due to the increases in the number of individual investors and the amount of money invested in mutual funds, hedge funds, ETFs, insurance companies, and sovereign funds. However, supply of stocks has seen slower rate of increase as the number new companies issuing stocks have relatively slowly progressed.
  • The Shiller P/E ratio does not adjust for changes in dividend yield.
  • The Shiller P/E ratio is used in part to determine when to take position in relation to the mean.

However, the mean keeps changing as time passes. For any growing economy the mean of the historic Shiller P/E rises over time and for any recessionary period the mean falls accordingly. Over a 10-12 years’ period, typically a cycle completes with a bubble and a bust. So, if someone waits for reversion to the mean, he or she may have entirely missed the last two expansions.

Appendix

Appendix

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