CAPE and other market valuation factors
Jun 22 · 9 min
TL;DR — The optimal approach to investing is to buy profitable, solvent, and undervalued companies in markets that are not overvalued, and, to value those markets, it is best to use the combination of the CAPE factor, and those based on cash flows, which present the highest correlation between them.
Value of the CAPE factor from 1881 to the present day.
The CAPE (Cyclically Adjusted Price Earnings) factor is one of the best indicators of how overvalued or undervalued a market is.
Defined by Robert Shiller in his book Irrational Exuberance, its use became popular during the dot-com bubble. Its value is calculated as a variant of the standard P/E factor, dividing the market price by earnings, but instead of using the most recent year's earnings, as is done for the P/E calculation, the arithmetic average of the last 10 years' earnings is used as the denominator. This eliminates distortions and occasional peaks and dips in earnings, and thus the value of the ratio is more indicative of the relationship between the price and the earning power of the companies in the market under analysis.
As a general rule of thumb, factor values between 10 and 20 are considered fair valuations, values below 10 indicate undervaluation, and values above 20 are an indicator of overvaluation. In this post, Lyn Alden defines the usefulness, predictive ability, and limitations of this factor. Lyn summarizes the idea behind the definition of the factor in this way:
Here's the problem. During a recession, stocks fall, but corporate earnings fall sharply as well, which can temporarily raise the P/E ratio. Since we want to buy when the P/E is low, this gives us a false signal that the market is expensive, that we shouldn't buy, when indeed it's the best time to buy.
Despite the usefulness of this factor, demonstrated by several studies pointing out the strong inverse correlation between the value of the factor and the average market returns obtained over the next 15 years (see Lyn's article), the factor suffers, however, from some shortcomings:
- The inverse correlation between CAPE and future returns is not as strong in small markets or with little diversity of sectors and industries (which is the case in countries with small and specialized markets).
- Accounting changes in the definition of earnings by the IASB or FASB make the CAPE values of one period not strictly comparable with those of another period.
To overcome the first of these shortcomings, it suffices to apply the factor only to heterogeneous markets with a minimum number of companies.
The second deficiency is more complicated to overcome and is because of the factor used in its calculation, the book value of earnings as published by the companies in their financial statements. Current generally accepted accounting standards as defined by the IASB/FASB are based on the accrual method, which requires adjusting the annual profit to reflect all expenses and all income for the current period. The problem is that these accounting standards allow some flexibility in defining this matching of income and expenses to the current period.
For example, we can change the period's expenses by increasing or decreasing the depreciation periods of the assets, or the amounts to be provisioned for the estimate we make of the possible impairment of an asset.
Unlike profits, free cash flows do not allow this accounting flexibility (in this post we analyze the relationship between both factors). If we change the definition of CAPE from earnings to free cash flows, we will obtain a more reliable factor that is less vulnerable to the arbitrary application of these accounting rules.
In this way we can define the following alternatives to the CAPE factor:
- P/FCFE: size-weighted average market capitalization (P) in relation to the size-weighted moving average (10 years) free cash flow to equity (FCFE) of all the companies in the selected market.
- EV/FCFF: size-weighted average enterprise value (EV) in relation to the size-weighted moving average (10 years) free cash flow to the firm (FCFF) of all the companies in the selected market.
In the long run, earnings and accounting cash flows should converge to the same average or cumulative value (see https://gradement.com/investing-blog-post/teleportation?lang=en), so that, in theory, there should be a high correlation between CAPE and the cash flow factors, since their calculation uses cumulative average values of earnings and cash flows over several accounting periods.
For the US market, there is a very high correlation between these valuation factors and the CAPE. The Spearman correlation between all factors is greater than 0.8, and the Pearson correlation is greater than 0.9 (see https://gradement.com/markets/unitedstates?lang=en).
In other smaller markets, these high correlation values are not always the case. In these markets, it is useful to have these alternative valuation indicators to CAPE, based on cash flow values, and to analyze the correlation between them. This way, we can select as a valuation measure the set of factors with the highest correlation between them, and discard the one or those least correlated with the majority, since the fact that several different factors have a high correlation is an indication that they are correctly measuring what we intend to analyze.
The Importance of not buying in overvalued markets
Even if you are a fundamental investor, focused on the financial and economic analysis of a given company, it is always important to have an idea of how undervalued or overvalued the market in which we are investing is.
The price of any stock always shows, to a greater or lesser extent, a certain correlation with the market in which its shares are listed. This correlation is measured with the beta factor. The higher the beta value, the higher the correlation with the market.
This implicit correlation means that, even if an investor has found a profitable, solvent, and undervalued company, if the general market is overvalued, any major correction in that market will affect that company's share price to a greater or lesser extent.
Yet, even if we buy in overvalued markets, if the company we buy is profitable, solvent, and undervalued, it is very likely that in the long term the investment will be profitable, since eventually, the market will recognize, via price, the profitability and solvency of the company. But if the investor had waited to buy the company until the market was undervalued or reasonably valued, the investment will be profitable in the short term, and in the long term, the profitability of the investment will be even higher, as the investor will have been able to buy the company at a much lower price due to the correction of the underlying market.
As fundamental investors, it is not enough to analyze a company's accounts. Before investing, we must always consider how overvalued or undervalued is the market in which the firm is listed.
The optimal approach to investing is to buy profitable, solvent, and undervalued companies in markets that are not overvalued, and to value the market it is best to use the combination of the CAPE factor, and those based on cash flows, which present the highest correlation between them.