Shiller Price to Earnings ratio. How is it calculated and what are its advanatages and disadvantages compared to a simple PE ratio with no adjustments for inflation?

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Shiller Price to Earnings ratio. How is it calculated and what are its advanatages and disadvantages compared to a simple PE ratio with no adjustments for inflation?

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Assuming you’re talking about CAPE (cyclically adjusted price-to-earnings ratio), the important difference vs. regular P/E is the use of an average earning-per-share in the denominator (typically 10-year average).

This is useful when valuing established businesses for investment over long time horizons. Say you are looking at businesses in an industry like construction, which has clear cyclical growth and downturns over years. Valuing it at current P/E is not just a reflection on current Price, but also on the Earnings for when (which stage of the cycle), you’re doing the valuation. The result is not reflective of whether the company is cheap or costly over the next 20, or 30 years. If you’re doing the valuation in a downturn, the Earnings over the next 20 years won’t be at the downturn level. Ditto for growth phases.

Instead you should use the average Earnings across the industry cycle.

Now if you’re taking average Earnings across multiple years, you *need* to adjust the numbers for inflation (historical financial statements are not automagically adjusted up to current dollar values). If you’re not adjusting for inflation, you would be using an unrealistically lower earnings number (because a dollar 10 years ago was worth more than a dollar now).