When you should use the CAPE ratio instead of the PE ratio

Julie Brownlee, Fsp Invest, 27 Oct. 2015

Tags: pe ratio, price earnings ratio, cape ratio, cyclically adjusted price earnings ratio, valuing a stock, investing in shares,

If you’re looking to invest in shares, valuing a company is a very important aspect of weighing up a prospective stock.

The most common way to value a stock is the price earnings (PE) ratio. Yet there is another way to value a stock, the cyclically adjusted price earnings (CAPE) ratio.

So which is the better option for you to use as an investor?

Read on to find out…

What is the PE ratio?

To calculate the PE ratio, you take the current share price of a company and divide this by the current earnings per share (EPS).

You can also use forecast earnings per share to get what is called the forward PE ratio.

The PE ratio gives you an idea of the value of a company.

If a company has a low PE ratio, it’s cheaper. If a company has a high PE ratio, it’s more expensive.

You can also use the PE ratio of a market to give you a benchmark to compare shares’ PE ratios to.

What is the CAPE ratio?

To calculate the CAPE ratio, you take the current share price of a company and divide this by the average EPS over a number of years. This is usually between seven and ten years.

The idea is that by using an averaged earnings figure, it’s more representative than looking at one year as the PE ratio does.

The CAPE ratio can be useful when researching cyclical companies. Cyclical companies see their profits rise and fall with what’s going on in the wider economy. To use the PE ratio for cyclical companies can be misleading.

The CAPE ratio tells you whether a share or market is cheap or expensive based on its long-term average.

So there you have it. When you should use the CAPE ratio instead of the PE ratio.

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