CAPE: How to find out if shares are really cheap or expensive

Julie Brownlee, Fsp Invest, 19 Aug. 2014

Tags: cape, what is cape, cyclically adjust price earnings ratio, pe ratio, financial ratio, how to find cheap shares,

The price earnings (PE) ratio is one of the most cited financial ratios. It can be a handy ratio to use, but it has its shortfalls.

The good news is, there’s a modified version of the PE ratio. This deals with some of the issues with the PE ratio.

So what is this other ratio?

Read on to find out…

The problem with using the PE ratio

One of the easiest and quickest ways of valuing a company is to look at its PE ratio. You can calculate a company’s PE ratio by dividing its current share price by its latest or forecast earnings per share (EPS).

You can also look up the PE ratio of a share on a host of online financial sources.

The major issues around using the PE ratio is that as it uses a company’s current profit level (earnings), this might not be a true reflection of what goes on within a company apart from the year you’re looking at.

This can be problem when you look at companies in cyclical sectors. For instance, manufacturing companies and airlines.

Profits in these companies tend to move about according to what’s going on in the economy. So you could misinterpret the PE if the earnings used aren’t a true representation of what’s going on in a business over the long-term.

For example, shares in a construction company might look cheap when you look at its PE ratio during a boom time in infrastructure. But if a recession follows, a construction company’s profits will fall too.

So this is where this modified PE ratio comes in…

What is CAPE?

CAPE is the cyclically adjusted price earnings ratio. To use CAPE, you average out a company’s profits over a number of years. Usually anything from seven to ten years.

By taking an average, it takes into account any economic ups and downs. To put it another way, you adjust the PE ratio to take into account what’s going on in the economy.

To calculate CAPE, you take a company’s share price and divide that by its average earnings per share.

CAPE is a great way of checking if a company is really cheap or expensive compared to what’s gone on with its profits over the long-run.

So there you have it, how to find out if shares are really cheap or expensive with the CAPE ratio.

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