There are many different metrics and ratios that analysts use to value stocks and markets. It can be very helpful for value investors to know what they mean and what they are used for.
The Shiller price-earnings ratio is one example of such a measure. It is often brought up in discussions of valuation for a specific stock, sector or even an entire country.
What is it, and how does it work?
Analysts use the Shiller price-earnings ratio to assess whether a given stock or market is overvalued or undervalued.
As you probably know, the regular price-earnings ratio of an asset is simply the price of the asset divided by its earnings. The normal price-earnings ratio can be a very useful rough guide to stock valuation, as it can give you a "ballpark feel" for whether something might lie in value territory.
However, one problem with the regular price-earnings ratio is that it does not take into account broader market conditions. During recessions, a company will typically post lower earnings simply because of the state of the economy. Its price-earnings ratio will therefore be higher than annother type of business that posts higher earnings during economic recessions. One way to account for this is to use the average earnings of the last few years in your calculation of the price-earnings ratio.
The Shiller price-earnings ratio, as defined by its creator Robert Shiller of Yale University, further refines this approach by taking inflation into account. If you are taking the average earnings from the last ten years, you need to be able to compare a company’s 2010 earnings to its 2020 earnings on a level basis. Thus, if a business had $1 in earnings per share in 2010, then in 2020 money that would equal about $1.18 (a 17.6% cumulative rate of inflation). This is significant because ignoring inflation results in an "apples to oranges" comparison which is not very useful.
Back in January, the Shiller price-earnings ratio of the S&P 500 was around 31.5, which was significantly higher than the historical average range of 15-20. Actually, this was the highest that the indicator had ever gotten other than in March 2000, at the height of the dot-com bubble. Going into the current bear market, the S&P 500 was more overvalued than it had been at almost any other point in history.
In summary, the Shiller price-earnings ratio is a more refined approach to valuation than simple price-earnings, as it accounts for inflation as well as the ups and downs of economic cycles. As history has shown, it tends to be higher than average right before market downturns occur.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: Investing Blunders to Avoid
- Jim Chanos: Where Do Shortsellers Get Their Edge?
- Stanley Druckenmiller: Risk-Reward Is Not Good Right Now
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