Everything you need to know about the CAPE ratio
We’ve talked a lot about ratings in this area. The valuation mainly relates to the current profits (earnings) that you will get when buying a stock. Remember that by purchasing a share you become a partner in that company. And as a business partner, in addition to the debts and other liabilities, you own part of the profits and any dividends.
We mainly want to own profitable companies. If you give a company $ 100 and it makes $ 10 out of the $ 100 for you, it’s a very profitable investment. It could be better than buying your way into a company that makes 50 cents on your $ 100 investment. Yes, it can take a while to make or get your money back, and the pace of growth for the company is also an important factor. A company may not have significant ongoing profits, but if it grows its revenues quickly, the prospect of generous future profits is good.
We looked at each other in mid-February Shopify’s revenue and growth. While the Canadian tech darling was new to the game of actually making a profit, its growth has been and continues to be incredible. Thanks to ever higher share prices, investors were rewarded for the growth.
Put simply, investing in stocks can depend on current earnings and future prospects.
In terms of ratings, you may have heard of the CAPE ratio. CAPE stands for cyclically adjusted price / earnings ratio (Relationship). Adjusted cyclically means that the valuation method smooths the corners and edges of the data over time. It is meant to provide a more accurate reading of the valuations and prospects for future stock returns. It cannot predict the timing of stock market corrections, but it does provide a very good measure of the prospect of returns over time.
This link from Meb Faber, the Chief Investment Officer at Cambria Investment Management, shows that a very high CAPE ratio (lower earnings) usually delivers very low returns over a period of 10 years. A low CAPE rate (higher income) usually provides very generous income over a period of 10 years. But it’s not an exact science. There are outliers. But most of the time, revenue plays a role over time.
In fact, according to 80%, earnings provide explanatory power for stock performance this tweet from Scott Barlow by Globe and Mail, referring to a study by Bank of America. (Look for item # 2 on this list.)
So, yeah, investors might want to dampen their excitement for US stocks.