P/E 10 Ratio

The Price-to-Earnings (P/E) ratio is one of the most commonly used metrics in equity valuation. It measures the current share price of a company relative to its per-share earnings. However, while the standard P/E ratio uses earnings from the latest fiscal year, the P/E 10 ratio (also known as the CAPE ratio or Shiller P/E ratio) takes a longer-term perspective by averaging earnings over the past ten years. This approach aims to smooth out the volatility that can occur from year to year, providing a more stable and long-term valuation metric.

Introduction to P/E 10 Ratio

The P/E 10 ratio was popularized by Yale economist Robert Shiller, who argued that short-term earnings can be highly volatile due to business cycles and other factors. By using a 10-year average of earnings, the P/E 10 ratio adjusts for these fluctuations and provides a more consistent measure of whether a stock or the stock market in general is overvalued or undervalued.

Formula for P/E 10 Ratio

The formula for the P/E 10 ratio is fairly straightforward:

[ \text{P/E 10 Ratio} = \frac{\text{Current Share Price}}{\text{Average Inflation-Adjusted Earnings of the Past 10 Years}} ]

Calculating the P/E 10 Ratio

To calculate the P/E 10 ratio, follow these steps:

  1. Collect Historical Earnings Data: Obtain the company’s earnings data for the past ten years.
  2. Adjust for Inflation: Adjust these earnings figures for inflation to ensure consistency. This is usually done using a measure like the Consumer Price Index (CPI).
  3. Calculate the Average: Compute the average of the inflation-adjusted earnings.
  4. Determine Current Share Price: Find the current share price of the company.
  5. Divide Current Price by Average Earnings: Finally, divide the current share price by the 10-year average of inflation-adjusted earnings.

Importance of P/E 10 Ratio

The P/E 10 ratio is important for several reasons:

  1. Long-term Perspective: By averaging earnings over a decade, the P/E 10 ratio removes the noise of short-term earnings spikes and troughs, providing a clearer view of long-term trends and valuations.
  2. Economic Cycles: The 10-year average smooths out the effects of economic cycles, making it easier to assess the true value of a company or market.
  3. Inflation Adjustment: Adjusting for inflation ensures that the earnings figures are comparable over time, removing distortions caused by changing price levels.
  4. Historical Comparisons: The P/E 10 ratio can be compared over long time periods to analyze whether markets or specific stocks are trading close to historical averages, helping to guide investment decisions.

Case Study: The S&P 500 and P/E 10 Ratio

One prominent application of the P/E 10 ratio is its use in evaluating the valuation of the S&P 500 index. Investors and analysts use the P/E 10 ratio to assess whether the U.S. equity market as a whole is overvalued, undervalued, or fairly valued. Historic data reveals that during periods of significant overvaluation, as indicated by a high P/E 10 ratio, the market tends to experience corrections. Conversely, low P/E 10 ratios have historically preceded periods of market growth.

Limitations of the P/E 10 Ratio

Despite its advantages, the P/E 10 ratio is not without its limitations:

  1. Historical Data Dependence: It relies on historical data, which may not fully capture future growth potential or changing business conditions.
  2. Inflation Metrics: The method of inflation adjustment (using CPI or another index) can introduce its own biases.
  3. Sector Variations: Different sectors have different average P/E 10 ratios due to variations in growth rates, capital requirements, and other industry-specific factors.
  4. Regulatory and Market Changes: Changes in regulations, technological advancements, and macroeconomic shifts can all affect a company’s earnings in ways not reflected by historical figures.

Applications in Algo-Trading

The P/E 10 ratio can be particularly useful in algorithmic trading (algo-trading) strategies that rely on fundamental analysis. Here are some ways that algo-traders might incorporate the P/E 10 ratio:

Value Investing Strategies

Algo-traders can design algorithms to screen for stocks with low P/E 10 ratios, indicating they may be undervalued. These stocks can be targeted for long positions in anticipation of future price increases.

Market Timing Signals

Traders can use the P/E 10 ratio of market indices (e.g., S&P 500) as a signal for broader market conditions. A very high P/E 10 ratio might prompt algorithms to reduce market exposure or even short the market, anticipating a correction.

Risk Management

The P/E 10 ratio can be integrated into risk management frameworks. For example, algorithms can adjust position sizes based on the P/E 10 ratio, increasing holdings in undervalued markets and decreasing them in overvalued markets.

Comparisons with Other Valuation Metrics

P/E Ratio

PEG Ratio

Price-to-Book Ratio

Notable Companies Utilising P/E 10 Ratio

Research Affiliates

Research Affiliates, founded by Rob Arnott, is well-known for its research in fundamental indexing and has used metrics like the P/E 10 ratio to construct portfolios. More information can be found on their homepage: Research Affiliates.

Grantham, Mayo, & van Otterloo (GMO)

GMO, co-founded by Jeremy Grantham, utilizes mean reversion strategies incorporating the P/E 10 ratio to forecast long-term market returns. For more details, visit: GMO.

Conclusion

The P/E 10 ratio is a robust tool for long-term valuation, offering a more stable perspective by averaging earnings over a decade and adjusting for inflation. Its applications in trading, particularly in algo-trading, are numerous and versatile, ranging from value investing to market timing and risk management. Though it has limitations, the P/E 10 ratio remains a vital part of the investment analyst’s toolkit, providing essential insights into market valuation.