The price earnings ratio is calculated by dividing a company's stock price by its earnings per share. In other words, the price earnings ratio shows what the market is willing to pay for a stock based on its current earnings. It is one of the most widely-used valuation metrics for stocks. A high P/E ratio suggests that investors are willing to pay a premium for each unit of earnings, indicating optimism about future growth prospects. Conversely, a low P/E ratio may indicate that the market has lower expectations for future growth or that the stock is undervalued.
The PE ratio of the S&P 500 divides the index (current market price) by the reported earnings of the trailing twelve months. In 2009 when earnings fell close to zero the ratio got out of whack, resulting in an inaccurate reflection of the market's true valuation. A solution to this phenomenon is to divide the price by the average inflation-adjusted earnings of the previous 10 years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced this adjusted ratio to a wider audience of investors. The Shiller PE Ratio of the S&P 500 is illustrated below.
Instead of dividing by the earnings of one year (see first chart), this ratio divides the price of the S&P 500 index by the average inflation-adjusted earnings of the previous 10 years. The ratio is also known as the Cyclically Adjusted PE Ratio (CAPE Ratio), the Shiller PE Ratio, or the P/E10. By using this adjusted ratio, temporary fluctuations in earnings are smoothed out, providing a more comprehensive view of the market's valuation.
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