Cyclically adjusted price-to-earnings ratio

Imagine you have a piggy bank where you save your pocket money every week. Sometimes you save too much money and sometimes you don't save enough. However, at the end of each year, your parents count all the money in your piggy bank and divide it by the number of weeks in that year. This helps them figure out how much money you saved on average per week.

Similarly, companies also make money every year through their operations and they tell their investors how much money they made (called earnings) during that year. Investors want to know whether the company made a lot of money or not as that will help them decide whether to invest in the company or not. However, not all years are the same for companies- sometimes they make a lot of money and sometimes they make less. So, just like your parents divide your yearly savings by the number of weeks, investors also divide a company's earnings over a number of years to figure out how much money it made on average each year. This is called Price to Earnings ratio or P/E ratio for short.

Now, instead of just looking at one year of earnings, some investors look at a company's average earnings over a period of time, for example, 10 years. This is because one year's earnings might be unusually high or low due to certain circumstances, like a pandemic. By averaging the earnings over several years, investors get a better understanding of how much a company makes on average, regardless of whether individual years were good or bad.

A cyclically adjusted price-to-earnings (CAPE) ratio is a type of P/E ratio that helps investors take into account the cyclical nature of businesses. Some businesses tend to make more money in good economic times, and less money in bad economic times. For example, restaurants might do better when people have more disposable income to eat out, and survive on takeout during economic downturns. Similarly, retailers might sell more clothes when people have more money for discretionary spending, but less when people have to save.

The CAPE ratio looks at a company's earnings over a period longer than just one year, usually 10 years. But, it takes into account that some years are better than others, so it adjusts the earnings for inflation, and compares them to the average earnings over that period. This helps investors understand whether a company is performing well overall, even if it had some down years due to economic cycles.

So, in a nutshell, the cyclically adjusted price-to-earnings ratio helps investors see how a company's earnings have performed over a long period of time, while taking into account any ups and downs caused by economic cycles.