Well yeah, according to the Wikipedia entry for CAPE ratio, the idea is at least as old as Benjamin Graham's Security Analysis, although the specific term "CAPE" usually refers to Bob Shiller's 10-year methodology.

Obviously you don't want to use P/E ratios based on a single data point, since that leads to meaningless statistics in a similar vein to my greatest pet peeve of financial media reporting, the infamous "corporation X increased profits by 2,584.32% last quarter!" (so what?).

But how you want to smooth out past earnings, and/or blend it with estimates of future earnings, is more art than science.

This gets into the similar issue of using PEG ratios, which adjusts P/E ratios for expected growth (since rational investors will bid up prices to higher P/E ratios when expected CAGR's for earnings are higher).

But then how do you estimate future growth? Not only for a single corporation but also for a particular country's stocks? (And for that matter, how do you know how much a particular country's stocks will branch out into emerging markets, capturing equity from foreign subsidiaries?)

How do you use common sense and say something like "the last 3 years aren't very characteristic of future earnings," or something similar?

It has to do with experience, gut, intuition, common sense, and all that jazz.

ETA: And related to this...

quote:
Just curious as to thoughts here re: weighting or importance of the comparisons.

The way I look at them, P/E ratios are pretty much everything when it comes to investment allocation across large asset classes (as opposed to say doing CAPM or APT or Fama-French calculations for alpha for some high-low strategy within a particular sector, or DCF/NPV calculations for a very specific project) ... once you've worked out all the necessary adjustments.

You adjust P/E ratios for smoothing to make then CAPE ratios. You adjust them for future growth estimates to make them PEG ratios. You can adjust them for expected volatility in earnings or in foreign exchange rates (LOLZ Argentina). But once you do all these adjustments, you should theoretically have a pretty clear metric for which class of equity has the most attractive price (even if your estimates for guessing what that metric is are necessarily very rough and back-of-the-envelope-esque).

EDIT2: It looks like an excellent time to go enable some Zionists...

quote:
Israel 11.32

This post was edited on 8/6/13 at 1:19 pm

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Posted by NC_Tigah

Carolinas

Member since Sep 2003

124322 posts

Posted on 8/6/13 at 1:31 pm to Doc Fenton

quote:
Bob Shiller's 10-year methodology

Right.
Faber's schtick is application of Shiller's PE ratio calcs (first applied to the S&P) to various international indices. Fortune had a nice write up on it recently (can't find it online though).

Was surprised at some of the market-to-market CAPE disparities. Will probably use new purchases to rebalance a bit toward non-emerging foreign markets.