Shiller P/E Ratio and Normalized Earnings: An In-depth Analysis

This report provides an in-depth analysis of the Shiller P/E Ratio, also known as the Cyclically Adjusted Price-to-Earnings Ratio (CAPE), and its relationship with normalized earnings. It explains the general concept of the Price-Earnings (P/E) ratio, highlighting its importance in equity valuations and how it is influenced by a company's earnings per share (EPS). The report emphasizes the significance of normalized earnings, particularly when considering long-term periods, and the limitations of using a single period for analysis. It then delves into the implications of the Shiller P/E Ratio, especially in the context of economic instability and financial crises, such as the 2008 global financial crisis. The report discusses how the Shiller P/E Ratio adjusts for inflation, financial problems, and unusual expenses to provide a more accurate assessment of a company's market value. The conclusion stresses the importance of applying the Shiller Ratio, which considers historical data to provide a fairer valuation of EPS, especially during periods of economic fluctuation. References to key academic papers are also provided.

NORMALIZED EARNINGS
AND SHILLER RATIO
IMPLICATIONS

• Normalised earnings are suitable only if
the period taken under consideration is
stable in nature.
• One single period may or may not be
economically stable.
• The normalised earnings depend on the
earning stability of the company.
• It is to be noted that if a long time frame
is considered then the economic and the
financial stability of the company does
not necessarily remain the same.
INTRODUCTION
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The Shiller P/E Ratio had been introduced
by Robert Shiller of Yale University. It is
also known as the Critically Adjusted Price
to Earnings Ratio or CAPE Ratio or the P/E
10 Ratio (Clare et al. 2017). It adjusts the
past earnings of the company with respect to
the inflation, any financial problems, and
unusual expenses and incomes.
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SHILLER P/E RATIO

GENERAL CONCEPT OF PRICE EARNING
RATIO
The normal price earnings ratio states the
relationship between the stock price and the
earning per share of the company. It helps
the investors in determining the stock’s
market value with respect to the earnings of
the company (Baek and Lee 2018). The
price earnings ratio can be determined by
using the below formula:
P/E Ratio = (Price Per Share) / (Earnings
Per Share)
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• P/E Ratio is a very important and famous tool for
equity valuations.
• It is dependent on the earnings of the company.
• The variation in the profitability of the company
impacts the P/E Ratio as the EPS also changes.
• There can also be a change in the price level because
of inflation.
• It is fine to use the normalised earnings if the periods
under consideration is normal (Cooper 2016).
• This means that the price level in the period must
remain constant.
• There should not be any changes in the rates that can
affect the price. 5
NORMALIZED EARNINGS

10 YEARS P/E AND IMPLICATIONS
• It has to be understood by the
investors that the past decades
have been anything but normal.
• This means that there always
remains a fluctuation in the
business cycle (Siegel 2017).
• The price level does not remain the
same for ten long years.
• This is the reason the Shiller P/E
Ratio is taken under consideration.
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THE IMPLICATION AFTER THE GLOBAL
FINANCIAL CRISIS
• The global financial crisis of 2008
is one of the worst disaster that led
to the Great Recession.
• The price of the housing sector fell
by 31.8%. The unemployment was
above 10%.
• Assets price fell down and there
were insolvency of the debtors and
intermediaries.
• There was a global share crash.
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THE IMPLICATION AFTER THE GLOBAL
FINANCIAL CRISIS
• The financial crisis had serious
impact on the economy and it had
led to several fluctuations in the
market rates and the profitability
rates.
• The drastic change is taken under
consideration only in case of
Shiller Ratio unlike the traditional
P/E Ratio.
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• The analysis of a stock market variation
depends on the time period.
• Several variations can arise in the
economy that can affect the earnings of
the company.
• Most of the companies also suffered at
the time of the global financial crisis.
• The EPS abruptly changed because of
such crisis.
• Under such cases the concept of the
Shiller Ratio must be applied that will
take under consideration the past data and
thereafter provide a fair value of the EPS.
CONCLUSION
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Baek, C. and Lee, I., 2018. US stock market P/E
ratios, structural breaks, and long-term stock
returns. Journal of Business Economics and
Management, 19(1), pp.110-123.
Clare, A., Seaton, J., Smith, P.N. and Thomas, S.,
2017. Reducing sequence risk using trend
following and the CAPE ratio. Financial Analysts
Journal, 73(4), pp.91-103.
Cooper, I.A., 2016. Estimating sustainable
normalized operating free cash flow.
Siegel, J.J., 2016. The Shiller CAPE ratio: A new
look. Financial Analysts Journal, 72(3), pp.41-50.
REFERENCES
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April Hansson
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www.proseware.com
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