Wednesday 26 June 2013

The FTSE 100 Cyclically Adjusted Price Earnings Ratio (FTSE 100 CAPE) Update - June 2013

Ever since Bernanke opened his mouth about potentially easing back (not stopping) on the amount of Quantitative Easing he is undertaking each month we've seen the price of many asset classes fall.  This has included the FTSE100.  Am I worried about it?  Well as a person who is investing large amounts every month into the markets the answer is no.  I hear you ask why.  Well if I use the FTSE100 as an example I’ll show today that both company earnings and dividends  are rising.  Therefore a falling price combined with rising earnings and dividends simply means a higher dividend yield and earnings yield.  That means that I'm simply buying the market at better value.

Let’s now run the numbers.  The last time we looked at this dataset was on the 30 April 2013.

FTSE 100 Price

In early morning trade today the FTSE 100 was priced at 6,160.  That is a fall of 4.5% when compared with the 01 May 2013 Price of 6,451.  It’s still 17.1% above the 01 June 2012 Price of 5,260.  How this pricing compares with history can be seen in the chart below.

Chart of the FTSE 100 Price
Click to enlarge

This is a similar chart to that which you will see in many places within the mainstream media.  Let’s now remove the sensationalism by:

  • Correcting the chart for the devaluation of the £ through inflation.  For this dataset I use the Consumer Price Index (CPI) to devalue the £.
  • Plotting the Pricing on a logarithmic scale as opposed to a linear one.  By using this scale percentage changes in price appear the same.  

Looking at the chart this way reveals the FTSE 100 in a very different light.  That light shows that the compound annual growth rate (CAGR) in today’s £’s has only been 1.7%.  Correct it by the Retail Prices Index (RPI) and that falls to 1.0%.

Chart of the Real FTSE100 Price
Click to enlarge

FTSE 100 Earnings

As Reported Nominal Annual Earnings are currently 504, up from 481 on the 01 May 2013.  They are down 10.4% on last year and down 19.8% on October 2011’s peak of 628.  Or course this looks better than it really is as inflation flatters the result.  I therefore plot a chart below, again on a logarithmic axis, showing Real (inflation adjusted) Earnings performance over the long term.

Chart of Real FTSE 100 Earnings
Click to enlarge

This only tells half of the Earnings story as it is an absolute number and so doesn’t help us with assessing market value.  Let’s therefore divide the nominal Earnings by the nominal Price to calculate the Earnings Yield.  Today that’s 8.2% compared with 7.5% on the 01 May 2013.  It can be compared with history in the chart below.

Chart of FTSE 100 Earnings Yield
Click to enlarge

FTSE 100 Dividends

Dividends matter.  Today annual dividends for the FTSE 100 are 231 up from 226 on the 01 June 2013.  The Real inflation adjusted growth of FTSE 100 Dividends, which is what many long term buy and holders including myself are looking for, can be seen in the chart below.  Unfortunately I only have dividend data from 2006 but with time that will grow and it’s better than nothing.

Chart of Real FTSE 100 Dividends
Click to enlarge

If we divide Dividends by Price we get the Dividend Yield which is currently 3.8% and can be compared with history below.

Chart of Real FTSE 100 Dividend Yield
Click to enlarge

Valuing the FTSE 100 – The Price/Earnings Ratio (P/E or PE) and the Cyclically Adjusted Price/Earnings Ratio (aka PE10 or CAPE)

Many people use the FTSE 100 P/E as a valuation metric.  It’s actually nothing more than the inverse of the Earnings Yield shown above.  Today it sits at 12.2 which is down on last month’s 13.4.

Personally I prefer to use the FTSE 100 CAPE.  It was made famous by Professor Robert Shiller, who used it on the S&P 500, and it is the ratio of Real (ie after inflation) FTSE 100 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings.  Today the FTSE 100 CAPE is 12.4.  It was 13.0 on the 01 May 2013.

Both valuation metrics are shown in the chart below.

Chart of the FTSE 100 Cyclically Adjusted PE and FTSE 100 PE
Click to enlarge

Does it work?  Well only time will tell but what I can say is that history suggests it has some value.  If we look at a history of 5 Year Nominal Capital Gain of the FTSE 100 and compare that with the two valuation metrics we find:

  • The P/E has a correlation of -0.27 which is considered a weak or low correlation.
  • The CAPE has a correlation of -0.45 which is considered a moderate correlation.  So it’s not perfect but it’s better than P/E when looking over longish periods which suits an investor like me.

A chart showing historic CAPE to 5 Year Capital Gain is shown below.  With the CAPE at 12.4 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 67%.

Chart of the FTSE 100 CAPE versus 5 Year FTSE 100 Capital Gain
Click to enlarge

Some other CAPE metrics that may be of interest:

  • The correlation between the Nominal FTSE100 Price and the FTSE100 PE10 is 0.18.  This is considered a weak or low correlation.  The correlation between the FTSE 100 Real Price and the FTSE 100 PE10 is a much more impressive 0.65.  This is considered a moderate correlation bordering on a strong or high correlation.
  • The Dataset Average FTSE 100 PE10 is 19.0.  Assuming this is “fair value” it indicates that the FTSE 100 is 35% undervalued today.  I’m not so comfortable with this call and think that may be a function of the fact that the dataset is quite short.  I therefore rely on there being a high correlation between International Equities and UK Equities to make a correction for this short period.  My mature S&P 500 dataset shows that from 1881 to present we have seen an average PE10 of 16.5 and from 1993 to present (the length of my FTSE 100 dataset) we have seen a much higher average PE10 of 26.5.  If I ratio these two numbers and multiply by the Average FTSE 100 PE10 I get a pseudo “long run” Historic FTSE 100 PE10.  Doing the maths this is (16.5/26.5)x19.0=11.8.  Comparing that number with today’s PE10 of 12.2 suggests we are nearly back to fair value with only a 5% over valuation
  • The Dataset Median FTSE 100 PE10 is 19.3.
  • The Dataset 20th Percentile S&P 500 PE10 is 13.9.
  • The Dataset 80th Percentile S&P 500 PE10 is 22.9.

Making Personal Investment Decisions from this Data

My Retirement Investing Today Strategy drives tactical allocations from CAPE values.  It uses the FTSE 100 CAPE to set my allocation to the UK Equities portion of my portfolio.  This is strategically set at 20% of total wealth.  By adding the FTSE CAPE tactical spin on top, as detailed in the Strategy, it forces a lower tactical allocation target of 19.2% today.

As always do your own research.

Assumptions include:

  • UK CPI inflation data for June 2013 is estimated.


  1. Hi RIT

    Good to see you still putting this stuff out there. CAPE is now pretty "mainstream" among active investors. We just need them to mention it on the 9 o'clock news rather than saying that the FTSE fell 0.3% today etc.


  2. Thanks again for your analysis.

  3. I think you are being rather generous to the mainstream media there. Rarely will you find any emphasis on percentages. After all, who knows how that kind of non-sensationalist black magic (maths) works?

  4. Nice work. It maybe risky to project divided growth based on the last few years. Companies have been:

    a. reducing debt servicing costs by taking advantage of unusually low interest rates
    b. paying out more in dividends because they don't see a case for expansion in the face of weak demand

    These are atypical and temporary factors. You should perhaps look at gross revenues and profitability metrics if you can find the data.