What Is the Meaning of CAPE? (Part 2)

Fundamentals behind the CAPE (cyclically adjusted price/earnings ratio).

Michael Rawson, CFA 07.01.2016
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In part 1 of this article, we walked through how CAPE has trended in the past. Now, let’s take a look at the fundamentals behind the CAPE.

The Fundamentals Behind the CAPE
The gradual rise of the CAPE could be owed to shifting fundamentals. The fundamentals that drive the CAPE are the same as those that underlie the P/E ratio. The P/E ratio is related to the dividend discount model, which says that the present value of a stock equals the discounted value of all future dividends. If we assume that dividends grow at a constant rate, we can simplify the dividend discount model to:

160107 CAPE 01(EN)

In the above formula, dividends are equal to earnings times the payout ratio (the portion of earnings paid out as dividends). Substituting this bit of multiplication in for dividends results in the following approximation:

160107 CAPE 02(EN) 

So the numerator of the right-hand side of the approximation is equal to dividends, while the denominator depends on the discount rate and the dividend growth rate. If we divide both sides of the approximation by earnings, we get the P/E ratio on the left-hand side:

160107 CAPE 03(EN)

The factors that justify an increase in the P/E ratio include a higher payout ratio, lower discount rates, or higher growth rates.

160107 CAPE 04(EN)

All else equal, lower dividend payout ratios should result in a lower CAPE. However, when the dividend payout ratio changes, all else is hardly equal. A lower dividend payout ratio equates to a higher earnings-retention ratio. Companies can do one of two things with retained earnings: invest them or buy back shares. Keeping the cash, rather than paying it out as a dividend, will result in earnings growth—even if the money just sits in the bank earning a nominal amount of interest. Buying back shares results in greater earnings on a per-share basis because the number of outstanding shares declines. Either way, a lower payout ratio should result in a faster earnings-per-share growth rate.

The impact of a lower payout ratio on the CAPE depends the relationship between payout ratios and growth rates. Between 1954 and 1992, the dividend payout ratio was around 50%. Since 1992, the dividend payout has been much lower, averaging 40%. This has translated into faster earnings-per-share growth. Between 1954 and 1992, 10-year average earnings per share grew by about 1.7% annualized. Since 1992, they have grown at about 3.4% annualized. Earnings growth doubled, but the payout ratio declined by only 20% (to 40% from 50%). This should result in a higher CAPE.

The discount rate depends on interest rates and the equity risk premium. The interest rate can be further broken down into an inflation component and a real interest-rate component. During the 1954–2010 period, when inflation rates were below 5%, the median CAPE was 20 compared with a CAPE of 10 when the inflation rate was above 5%. When real 10-year rates were below 6%, the median CAPE was 21, but the median CAPE was only 14 when real rates were above 6%. Inflation was estimated using the one-year previous and one-year forward Consumer Price Index inflation, while real rates were estimated by subtracting the inflation rate from the 10-year nominal Treasury rate. Low inflation and low real interest rates support a high CAPE.

Mind the GAAP
An additional factor lending support to a higher CAPE relates to the way earnings are reported. According to Jeremy Siegel,2 “Changes in the accounting standards in the 1990s forced companies to charge large writeoffs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold.” In other words, accounting standards have not been consistent over time and may be more conservative today than in the past. An above-average CAPE may be—in part—reflective of a rational adjustment to understated earnings caused by a change in accounting standards. However, it is hard to quantify the appropriate size of such an adjustment. As-reported earnings fell by 92% during the Great Recession, but they fell by 66% during the Great Depression, despite a deeper economic downturn. However, according to Standard and Poors, the S&P 500’s operating earnings fell by just 53% during the Great Recession. It seems reasonable to assume that the actual decline in earnings was closer to 53% than 92%. If investors believe that as reported earnings don’t accurately portray S&P 500 companies’ true earnings, they might make a corresponding upward adjustment to the CAPE’s denominator over the recent crisis period. The result? Today’s CAPE would not appear as high.

With the S&P 500’s CAPE currently registering near 26, returns during the next five years will almost certainly be lower than the 21% annualized return experienced during the past six and half years. Yet lower interest rates, faster earnings growth, and changes in accounting conventions are reasons not to panic over the current level of the CAPE.


2Siegel, J. 2013. “Don’t put faith in Cape crusaders.” Financial Times, Aug. 19, 2013.

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Michael Rawson, CFA  Michael Rawson, CFA is an ETF Analyst with Morningstar.

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