What is the Shiller P/E ratio?

Due to rising inflation rates and low key interest rates, you may be earning relatively low returns on your funds in money market accounts and savings accounts. Therefore, increasing numbers of newcomers are interested in investing funds and earning returns.

Now that you've learned about stocks in general, we'll take a closer look at the price-earnings ratio and an extension of the P/E ratio, the Shiller P/E ratio in this article. 

What exactly is the price-earnings ratio (P/E ratio)?

As you may remember, the P/E ratio of a stock shows how often the annual earnings per share are included in the price of the stock. In addition to individual stocks, you can also calculate the P/E ratio for entire stock markets, indices or economic sectors.

On Bitpanda, you don't need to calculate the P/E ratio for all our listed Bitpanda Stocks* yourself, because you can find the P/E ratio in the company's information and data - just find the stock* of your choice in our overview, click on it and then scroll down to see all the information about this stock, including all market statistics and downloads at the bottom of the page. But, in any case, it is helpful to know how you could calculate the P/E ratio yourself:

How do you calculate the P/E ratio?

To calculate the ratio (R) between the price of the stock (S) and the earnings per share (E) you first need the (in its simplest form, current) price of the stock (S), which you can find on a reputable financial website. *Please make sure that you always use reputable websites for your research. 

Then you need the annual profit per share (E). So if you wanted to calculate the basic earnings per share yourself, you would simply divide the company's annual profit by the total number of outstanding shares. 

Finally, to calculate the ratio, you divide the price (S) by the profit (E). For example: let's say the current price of a share (S) is €150.66 and in the previous year, the profit per share (E) was €5.67, so this calculation gives a P/E ratio of 26.57. 

Special factors and basic and diluted earnings per share

In practice, however, depending on the article of calculation, the annual profit itself is almost always adjusted for special effects and/or distributed dividends, which means that these elements are deducted from the net profit. This gives the undiluted earnings per share. 

In company reports, however, diluted earnings per share, a hypothetical key figure, are also provided. This indicates the quality of the earnings per stock. This is because this figure provides information on the hypothetical earnings per share if all of the company's convertible securities (such as stock options, convertible bonds and others) were converted into stocks. In this theoretical scenario, the number of shares would increase and the profit would be attributed to this higher number. This ratio is important for shareholders because it indicates the profit a shareholder would receive in a worst-case scenario.

Advantages and disadvantages of the price-earnings ratio (P/E ratio)

As you can see, it's not all that simple - and it's not getting any simpler. When calculating the P/E ratio, different initial figures are used depending on the desired insights, which can be based on different calculation methods or other factors.

Unreliable forecasts

Thus, not only is the profit of the previous year used, but forecasts are also used. For example, the forecast profit for a time frame in the future is also taken into account. Then, the calculated P/E ratio is marked as "estimated". For example, if a stock costs EUR 122 and the forecast profit for the next twelve months is EUR 12 per stock, this estimated P/E ratio is 10.16.

Of course, it is the nature of things that profit forecasts often turn out to be wrong - even the expectations of the stakeholders themselves are "priced in" to the current stock market prices. Therefore, only a P/E ratio that is based on the company's past performance is really reliable.

What can I use the P/E ratio for?  

The P/E ratio shows the total number of years a company has to generate the current (actual) profits in order to recoup the costs of investing in a stock through earnings. 

The higher the price-earnings ratio, the more a stock costs. It rises when prices increase faster than profits or, conversely, when profits fall faster than prices. The lower the P/E ratio, the less expensive the stock is usually described as. However, it is here that the figure should be treated with particular caution - but why?

Limited informative value of the P/E ratio

Of course, the assumption that profits remain constant every year is not realistic, as numerous factors contribute to price development. For example, a high-growth company usually has a very high P/E ratio because the market's expectations of future performance are usually extremely high compared to any current results. 

A stock with a low P/E ratio may appear cheap, but this may be due to a drop in profits or other negative events in the background. The markets are in constant motion and prices rise and fall, so you should always keep an eye on the daily prices and the developments of the last weeks and months in your calculations, as well as the entire current company balance sheet. To sum up: the P/E ratio alone is not sufficient to value a stock.

It is also difficult for young companies to use the historical average of past annual results to obtain reliable figures. Furthermore, the comparison between different industries or companies based in different countries or on different continents is not necessarily meaningful or even possible in the first place. Finally, macroeconomic (overall economic) factors such as the development of the economy, key interest rates and inflation also play a role. 

What can I use the Shiller P/E ratio for?

In order to smooth out the fluctuations that can affect a company's profits due to the different time sequences in an economic cycle, the American economist and Nobel Prize winner Robert Shiller developed a modified version of the price-earnings ratio as a key figure - the CAPE ratio, also known as the Shiller P/E ratio or cyclically adjusted price-earnings ratio. This should facilitate long-term forecasts.

This variation uses real earnings per stock over a ten-year time frame. Financial analysts use the cyclically adjusted price-earnings ratio to assess long-term performance while isolating the impact of economic cycles. 

How do I calculate the Shiller P/E ratio?

The CAPE ratio (Shiller P/E ratio) can thus be used to refer to the profitability of a company over different time frames within an economic cycle, because the ratio also takes fluctuations into account, including phases of expansion and recession. For the simplest calculation, the price of the stocks is divided by the inflation-adjusted average profit of the last ten years. 

Thus, a notably high ratio here indicates that the company's share price is overstated relative to the company's earnings and that a correction is likely to occur. The Shiller P/E ratio could therefore also be used to identify potential bubbles and market collapses. 

Excess CAPE yield (ECY)

As Shiller had not taken the interest rate level into account in his original calculation method, he developed the concept further and introduced the excess CAPE yield (ECY). This is calculated by reversing the CAPE ratio and subtracting the real interest rate of the last ten years.

Shiller concluded that lower ratios over time automatically mean above-average price gains for investors. Nevertheless, this was only the case observed on an average basis. Another criticism of the Shiller P/E ratio is that it does not take amendments to accounting standards into account, which can affect the calculation of earnings.

What is the extent that I can rely on profit forecasts for?

In fact, you should bear in mind that when investing money, you should always keep the big picture in mind and not rely on long-term forecasts and expected returns. 

In the last few years alone, the behaviour of many investors, especially beginners, has changed, sometimes drastically. Instead of finding high-growth companies with promising long-term potential, investors are now increasingly using short-term and creative strategies to speculate on stock movements.

For example, the stock rush in early 2021 led to an unprecedented short squeeze that bankrupted several hedge funds and forced established financial firms to lose billions. A short squeeze occurs when many investors take short positions on a stock in the hope that the price will fall in order to buy it later at a lower price. 

If it comes to an excess of such "short selling" (where stocks are only "borrowed"), there is an excess demand for that stock and the price of the stock shoots up instead, as the short sellers now have to buy the stocks to cover their short positions.

Short-term moves can not only thwart sound long-term investment strategies. Instead, they can cause you (the investor) to miss out on the compound interest that accrues in the long term. As always, to plan your financial strategy from the ground up, it is best to do your own research and to acquire a solid knowledge base.  

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*This blog article is not intended to be used as a general guide to investing and should not be considered investment advice. Bitpanda Stocks allows investing in fractional stocks. Fractional stocks are always enabled via a contract in Europe that replicates the underlying stocks or ETFs (financial instruments pursuant to section 1 item 7 lit. d WAG 2018). Investing in stocks and ETFs involves risks. Further information is available in the prospectus, the supplements and the PRIIPs KIDs on bitpanda.com.