The price-to-earnings (PE) ratio is unarguably the most widely used valuation tool in the market because it is easy to apply and to interpret its results thereof.
If you want to know if a stock is expensive or not, you can simply divide the share price with its earnings per share to get its PE ratio and compare it with market average.
A stock with high PE ratio suggests that further upside in share price may be limited while a stock with low PE ratio indicates it is cheap and can offer huge potential returns.
In the early 1930s, legendary value investors Benjamin Graham and David Dodd noted in their classic book called Security Analysis that using earnings per share for the last 12 months to determine the PE ratio of a stock can be misleading.
Because of business cycles in the economy, fluctuations in quarterly earnings tend to make stocks look expensive at one point and cheap in the following period.
Graham and Dodd suggested that in order to lessen the impact of earnings volatility, one should smooth out the data by taking the average of a stock’s earnings for the last 10 years.
In 1988, a professor from Yale University by the name of Robert Shiller revived this suggestion and developed the Cyclically Adjusted PE ratio or CAPE.
Also known as the Shiller PE 10, the CAPE ratio aims to estimate the long-term returns of a stock by calculating its average earnings for the past 10 years with each year adjusted for inflation.
According to Shiller’s study, the CAPE ratio was strongly correlated with the expected returns of the stock over the next 20 years. A stock with high CAPE ratio will mean that it is overvalued with lower returns in the future and vice versa.
If we apply this over at the PSE, we can find that the current CAPE ratio of the market is about 26.3 times, which is 69 percent higher than the traditional PE of the market at 15.5 times.
At first glance, the high CAPE ratio makes the market look expensive because the earnings are lower, due to averaging from early years and adjustment from inflation.
But if we compare this ratio historically with previous years, current CAPE of the market is relatively undervalued.
Since 2014, the CAPE ratio of the PSE seems to be falling from 37 times to 32 times in 2016 and 27 times in 2018, as seasonally adjusted earnings grew by 13 percent annually in the past 10 years.
Being at the lower end of the range, there is a statistically good prospect that the CAPE ratio will eventually pick up and regress to the average.
At an average CAPE ratio of 33 times based on past five years, the PSE Index may potentially grow by 25 percent toward 10,000 in the long term.
Presently, about half of the 30 PSE Index stocks are trading below the market CAPE ratio of 26.3 times.
Among the stocks with the biggest discount to market is PLDT, which has CAPE ratio of only 9.8 times at 62.8 percent discount.
This is followed by Alliance Global with 12.6 times at 52 percent; Semirara Mining, 12.9 times at 50 percent; Aboitiz Power, 13.8 times at 47 percent and Aboitiz Equity Ventures, 16 times at 39 percent.
Despite the useful features of the CAPE ratio, it also has its own limitations. For example, a stock with low CAPE ratio may not necessarily be a good buy if there is a fundamental reason for its low valuation.
The same also goes with high CAPE stocks. Some stocks deserve to trade at premium because it has solid management track record and extraordinary growth prospects.
The CAPE ratio is inherently backward-looking. It uses historical data to determine the prospective value of a stock, which may not reflect current risk and growth outlook.
The ratio also does not consider the changes in accounting standards. The accounting for earnings may not be the same anymore as 10 years ago, making the average earnings inaccurate.
While the CAPE ratio may be practical tool in assessing stocks to improve long-term returns and lower investment risks, it should not be applied alone when it comes to making investment decision.