Why does the stock market return profits adjusted for inflation?

P / E ratio and Shiller P / E ratio - what the key figures say about stocks


From Markus Neumann

The classic price-earnings ratio (P / E ratio) and the so-called Shiller P / E ratio, which was developed by Nobel Prize winner Robert Shiller, are intended to show investors which stocks and markets are currently cheap. But can investors really suckle honey from these valuation barometers? Doubts are in order.

Valuation metrics such as the price-earnings ratio (P / E) are intended to help investors undervalued stocks to recognize who will deliver above-average returns in the future - according to the old merchant rule that the profit lies in purchasing. But if the stock exchanges really worked on such a simple mechanism, all investors would be as rich as Warren Buffett. So the question arises which one Benefits of the KGV actually brings?

The so-called Shiller KGV, named after the Nobel laureate in economics, Robert Shiller, who developed this key figure, should also be questioned. The Shiller P / E ratio is often used to value entire stock markets. The evaluation allows conclusions to be drawn about the average market returns over the next ten years.

That's why this will Shiller P / E ratio taken into account by some professional asset managers in strategic asset allocation, for example. Highly valued markets are weighted lower in the portfolio - and vice versa. But the Shiller P / E ratio is also not reliable, as studies and the recent past show.

Despite all the shortcomings, the classic P / E ratio and the Shiller P / E ratio are a reference point for investors who want to get an idea of ​​whether certain stocks or stock markets are currently expensive or cheap. Because the absolute price of a share or the meter reading of a share index say nothing about its valuation. For example, stock market prices can rise sharply while stocks become cheaper at the same time.

The valuation is only revealed when share prices or meter readings of indices are set in relation to other variables, such as the Earnings per share. A trend can then be read from these relationships compared to historical averages.

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The classic price / earnings ratio

The classic P / E ratio, often too Price-earnings ratio or P / E for short, is the multiple of the earnings per share that investors have to pay for a share. The higher the P / E ratio, the more expensive the stock. In other words: The P / E ratio shows how many years it takes for the total earnings per share to match the current purchase price, under the - of course completely unrealistic - assumption that the level of earnings will not change over the years.

The multiple of a share is easy to calculate. In the simplest version, the current price is divided by the earnings per share for the past twelve months. This P / E ratio is referred to as a "Trailing P / E" designated.

Instead of the profit of the past four quarters, some data portals use the forecast profit for the coming year. If this is the case, the P / E ratio is usually given the addition “estimated”.

Calculation example: If a share costs 100 euros and the forecast profit for the next twelve months is 10 euros per share, the P / E ratio is 10.

The P / E ratio increases when stock prices rise faster than corporate earnings. Or when corporate earnings are falling faster than stock prices.

Profit forecasts are often wrong

So far, so easy. But there are a number of problems. For example, nobody knows exactly whether that P / E ratios based on earnings forecasts actually true. It can only be reliably calculated on the basis of past profits.

However, investors do not want to know whether a stock WAS expensive, but rather whether it IS expensive at the time of purchase. The decisive factor for this is the profit that the company will generate in the future. Because the current stock exchange prices already reflect investors' profit expectations. They are continuously "priced in", as it is often called.

Analysts estimate future earnings. The average of their forecasts is often used in calculating the P / E ratio. Unfortunately, these predictions can be far off.

Interpretation of the P / E ratio

How should investors interpret the P / E ratio? First of all, it is important to always have the current P / E ratio of a stock or that of an index in relation to its own historical average consider. Only then can the assessment be made available. If the current P / E ratio is below the historical average, which is viewed as the fair valuation, a share is considered cheap.

However, this approach has its pitfalls. Because there is no one-size-fits-all rule that says how far back in time investors should go when calculating the historical P / E average. Some experts say no more than 20 years because, for example, regulations for determining profits and market conditions are changing. Others argue that the entire time series that is available gives the best bar.

In any case, comparing the P / E ratio of companies from different industries is rather pointless. There are sectors that are always rated lower or higher than others. Technology stocks, for example, usually have a very high P / E ratio. Oil companies, on the other hand, have a low one. In this respect, only a comparison within the industry makes sense. The average P / E ratio in the sector can be used as a yardstick, for example, and compared with the valuation of an individual company in the sector.

A direct comparison is also problematic at the country level. Because, as with various industries, the long-term valuations of individual country markets differ significantly in some cases. Russia, for example, is always rated low compared to the USA. That doesn't mean that Russian stocks are necessarily cheap. Rather, they are reflected in the lower rating the higher risksThat the Russian stock market undoubtedly harbors in comparison to the United States. An indication of an under- or over-valuation is therefore more likely to be provided by comparing the current P / E ratio with the company's own historical average.

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KGV is unsuitable for price forecasts

However, the classic P / E ratio is no more than an indication of the valuation. The decisive question is why a company is cheap or expensive. This can only be seen if you use a number of other fundamental key figures, such as return on equity, and weigh them against each other.

Because a low P / E ratio can be justified if the future prospects of a company are poor. On the other hand, it regularly happens that the prices of some companies are quoted at a low level because they are not in fashion with investors, although they are generating decent profits. This then leads to undervaluations, which are reflected in a falling P / E ratio.

How high the fair value, the so-called fair value, of a share, but ultimately no one can say with certainty. It is a theoretical concept that is used in a wide variety of ways by stock market professionals. It is also in the stars whether the price of an undervalued share will ever rise again to its supposedly fair value.

In any case, there is no statistical evidence of a connection between the PER and future price development - even if the future profits were known. This is shown by a study by the investment company StarCapital. Accordingly, the classic P / E ratio is completely unsuitable for stock forecasts.

No statistical correlation between PER and future price development measurable

Source: StarCapital, as of December 2019.

If one could determine without a doubt with the help of the P / E ratio and other key figures which companies will have above-average prices in the future, it would be child's play to generate a higher return than the market average with the targeted selection of stocks. But that is not the case, as numerous studies and the underperformance of equity fund managers show. Rather, so-called stock picking is a very difficult matter that usually does not work.

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Robert Shiller's P / E to smooth out cyclical distortions

But there is another reason why the classic P / E ratio is problematic: The short-term view over 12 months leads to Distortions due to cyclical fluctuations. In the upswing, when profits are high, stocks appear cheap; in the downturn, when profits melt away, they look expensive.

To smooth out such distortions, the economist and Nobel laureate in economics Robert Shiller developed an alternative price / earnings ratio. The so-called Shiller P / E ratio, also known as the Cyclically Adjusted Price-to-Earnings Ratio (CAPE), is based on the average of inflation-adjusted corporate profits over the past ten years.

The difference to the classic P / E ratio was evident, for example, during the Financial crisis in spring 2009. At that time, the P / E ratio, based on the profits of the previous year, showed a historical high and thus an extreme overvaluation of the American stock market because the profits of the companies had plummeted. The Shiller P / E, on the other hand, signaled a low valuation of the market. In fact, buying US stocks at the time would have been a wise decision.

Classic P / E and Shiller P / E for the American stock market in comparison

Sources: Robert Shiller, Macrotrends.net, Fairvalue, as of November 2019.

The forecast quality of the Shiller P / E ratio is anything but perfect

Many investors who take a so-called value approach use the Shiller P / E to identify undervalued stock markets. The hope of above-average price gains is linked to the purchase of inexpensive stocks. In fact, future US stock market returns averaged high when the Shiller P / E ratio was low. Conversely, when the Shiller P / E ratio was high, returns were low on average.

On average, there were also many cases in which high valuations were followed by above-average returns and low valuations were followed by below-average returns. Historically, the bottom line is that the Shiller P / E ratio explains only 40 percent of the fluctuations in returns on the US stock market. Other factors therefore have a greater influence on the level of price gains and losses.

The weakness of the cape ratio was particularly evident in the past three decades. Since 1990, US titles have been overrated almost all of the time, and sometimes extremely. Nevertheless, the real return over this period was more than double compared to the long-term average.

Forecasts of long-term stock market returns based on the Shiller P / E ratio were correspondingly inaccurate. Many professional value investors use the Shiller price / earnings ratio or similar valuation metrics to estimate the returns for the coming years and to align their portfolios accordingly. However, because of the high stock market valuations and the equally high returns in the USA, these predictions were systematically too pessimistic.

Mean reversion is not a stable phenomenon

The forecasts with the help of the Shiller P / E ratio are based on the observation in the past that the market valuation repeatedly returned to its mean value over the long term. In financial market research this phenomenon is called Mean reversion designated. But in the US, the stock market that is mostly analyzed because of its data records going back far into the past, the return to the mean has largely not been seen in the recent past. Only in the early 1990s and after the stock market crash in 2008 did the Shiller P / E ratio briefly fall below its long-term average of just under 17, but remained far from the lows of the past (see chart above).

Critics therefore argue, among other things, that orientation towards the long-term average is misleading because it does not reflect the changed economic environment of low interest rates and low inflation. If one takes the average of the Shiller P / E ratio of the past three decades of a good 25, the picture is different. In terms of this, the market is still expensive, but it is not in such a gigantic bubble that the average has been signaling since 1881.

Scientists still disagree about whether mean reversion exists in the stock markets and whether investors can generate above-average returns on the basis of this phenomenon. According to the current state of affairs, mean reversion can be detected in some stock markets, but the evidence is only weak, say financial market researchers Elroy Dimson, Paul Marsh and Mike Staunton.

Investment strategies that are based on the P / E ratio are an uncertain undertaking

Investment strategies that are based on the assumption that stock market valuations keep moving towards their mean over the long term can work, but don't have to. Those who bet on undervalued stocks and stock markets can certainly achieve a worse return than an investor who pursues a simple buy-and-hold strategy with an exchange-traded index fund (ETF) on a global stock index such as the MSCI World.

The major difficulty is determining when to hold or overweight stocks and when to sell or underweight stocks. The research trio Dimson, Marsh and Staunton tested a promising approach for the stock markets of 20 developed countries: If the projected real return on the basis of the market valuation was negative for the next five years, they shifted the fictitious capital into short-term bonds. If the model's predicted return was positive, they held stocks. Your data set reached from 1900 to 2012, so it spanned 113 years.

The result: In no market was it possible to beat a buy-and-hold strategy in which an investor remains invested in stocks at all times. The forecasts had underestimated the actual returns.

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A simple approach with the Shiller P / E ratio has worked better in the recent past

Meb Faber, co-founder and chief investment strategist of asset manager Cambria Investment Management, pursued a simpler approach in an analysis from 2012, which at least worked in the past. From 30 countries, he selects the 33, 25 and 10 percent of the stock markets that were rated the lowest in terms of Shiller P / E ratio. All portfolio components were weighted equally. However, the prerequisite for an investment is that the Shiller P / E ratio does not exceed 15. If the rating of a country is higher, no investments are made there and the portfolio portion is held as cash without interest.

The portfolios were rebalanced annually, the composition was checked and, if necessary, individual country stock markets were exchanged. Faber tested these strategies with data series that only start in 1980, 1990 and 2000. The results are impressive: With all variants, the real annual return is considerably higher compared to a portfolio that invested consistently and equally weighted in all 30 countries (buy and hold).

The “cheapest 10 percent” approach achieved the highest return at 18.7 percent per year. The buy-and-hold portfolio generated only half as much at 9.4 percent annually. However, the risk in terms of volatility was higher for all Shiller P / E strategies than for the buy-and-hold portfolio.

On the other hand, the maximum losses, which are more important for investors, were considerably lower. While the buy-and-hold portfolio temporarily lost almost 50 percent of its value, the value of the value portfolios fell by just under 18 to a good 23 percent. The reason for this is the upper valuation limit of 15. It ensures that the portfolios contain up to 100 percent cash at times if all markets are expensive, as was the case during the dot-com bubble at the end of the 1990s.

Despite the clear results, there are no guarantees that these portfolio strategies based on the Shiller P / E ratio will continue to work. A test of how the trading approaches performed after 2012 is still pending.

The Shiller P / E ratio cannot predict reversal points in the stock markets

While the Shiller price / earnings ratio may seemingly serve well in country selection, it is unsuitable for predicting turning points in stock markets.No one can predict with any certainty which valuation level investors will drive a market up or down. In the mid-1990s, for example, the American stock market looked hopelessly overvalued with a Shiller P / E of 25. In the past, the market had repeatedly slumped sharply when it reached values ​​between 22 and 25 (see graph above). But share prices rose steadily for several years until the end of 1999. Before the bubble burst, the Shiller P / E hit one Record of almost 45 and did not even fall below 20 in the subsequent crash.

Today, too, the Shiller P / E ratio shows values ​​that it only reached during the dot-com bubble and shortly before the stock market crash in 1929. It is unclear to what extent the valuation figure can rise before a stock market crash occurs.

In any case, compared to the other international stock markets, the USA has done outstandingly in the past few years, although the country is rated the highest in the world (see table). Anyone who waived or underweighted US stocks because of this, had with the Portfolio return neglect. Why US stocks outperformed the rest of the world

The following table shows the valuation of the most important international stock markets as measured by the Shiller P / E ratio.

Tip: Click the column headings to sort the data in ascending or descending order.

Shiller P / E for the major international equity markets as measured by MSCI country and region indices

Fair value recommendations

All valuation metrics have their own weaknesses. It is therefore advisable to always look at several key figures and indicators in order to get an impression of the valuation of a market, an industry or an individual share. Stock markets that appear inexpensive are no guarantee of rising prices. Nor do expensive stocks have to fall again anytime soon. They can get much more expensive.

The classic P / E ratio and the Shiller P / E ratio neither provide reliable forecasts nor do they indicate reversal points on the stock market. You can get investors though a first warning sign deliver when adversity is brewing in the markets.

Sure, in hindsight you are always smarter. But if millions of investors at the end of the 1990s had oriented themselves to traditional valuation standards and the many other indicators that signaled that the stock markets were overheating, they might not have fallen into the loss trap.

© Fairvalue, updated on November 20, 2020

Photography: Kevin Dooley / Flickr (CC BY 2.0)


Elroy Dimson, Paul Marsh, Mike Staunton: Mean Reversion, Credit Suisse Global Investment Returns Yearbook, 2013.

Joseph Davis, Roger Aliaga-Diaz, Harshdeep Ahluwalia, Ravi Tolani: Improving U.S. stock return forecasts: A "fair-value" CAPE approach. The Journal of Portfolio Management, 2018.

Meb Faber: Global Value: Building Trading Models with the 10-Year-CAPE, 2012.

Successful investment is a strategic process.
Our free newsletter will help you optimize your portfolio.


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