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From ChatGPT. The last sentence summarises.
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The CAPE ratio (Cyclically Adjusted Price-to-Earnings)—popularized by Robert Shiller—uses 10-year average real earnings. Because it relies on reported earnings, accounting rule changes can materially distort it, even if the underlying economy hasn’t changed.
Here are the key accounting changes that affect CAPE and how they bias it:
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1. Changes in GAAP Earnings Definitions (More Conservative Reporting)
* Over time, Financial Accounting Standards Board (FASB) has pushed toward more conservative earnings recognition.
* Examples:
* Faster recognition of losses
* Stricter impairment rules
* Effect on CAPE:
↓ Reported earnings (especially in downturns) → ↑ CAPE (appears more expensive)
👉 This is one of the biggest structural reasons modern CAPE looks higher than pre-1990 levels.
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2. Treatment of Write-downs & Impairments (Goodwill, Assets)
* Modern rules require companies to write down goodwill and intangible assets when impaired.
* These write-downs:
* Can be large
* Are often one-time but included in earnings
* Effect on CAPE:
* Large negative earnings during crises (e.g., 2008)
* Depresses the 10-year average earnings
→ Artificially inflates CAPE for years afterward
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3. Shift from “Operating Earnings” to “Reported Earnings”
* Earlier decades often emphasized smoother operating earnings.
* CAPE uses reported (GAAP) earnings, which are:
* More volatile
* Include one-time charges
* Effect on CAPE:
* More volatility → lower average earnings → higher CAPE
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4. Stock-Based Compensation (Expensing Options)
* Before early 2000s:
* Stock options often not expensed
* After rule changes:
* Must be expensed as a cost
* Effect on CAPE:
↓ Earnings (especially in tech-heavy indices)
→ ↑ CAPE relative to earlier periods
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5. Pension Accounting Changes
* Firms now must:
* Recognize pension deficits more transparently
* Mark assets/liabilities closer to market
* Effect on CAPE:
* Adds volatility to earnings
* Often reduces reported profits
→ pushes CAPE higher
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6. Revenue Recognition Changes
* New standards (e.g., ASC 606):
* Change timing of revenue recognition
* Effect on CAPE:
* Can shift earnings across years
* Alters the 10-year average baseline
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7. Increased Use of Fair Value Accounting
* More assets marked to market instead of historical cost
* Effect on CAPE:
* Earnings become more cyclical and volatile
* Crisis periods show sharper losses
→ lowers average earnings → raises CAPE
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8. Tax Law Changes (Indirect Effect)
* Changes in corporate tax rates affect after-tax earnings
* Example: lower tax rates → higher earnings
* Effect on CAPE:
↑ Earnings → ↓ CAPE
(but this is economic + policy, not pure accounting)
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Big Picture Insight
The key pattern:
Modern accounting tends to depress and increase volatility of reported earnings relative to the past.
That means:
* Today’s CAPE is not directly comparable to early 20th-century CAPE
* A “high CAPE” today may partly reflect accounting evolution, not just overvaluation
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Practical Implications for Investors
* Comparing CAPE across eras without adjustment can be misleading
* Some analysts:
* Adjust earnings to remove one-time write-downs
* Use NIPA profits (national accounts) instead of GAAP
* Or compare CAPE only within the modern accounting regime (post-1990)
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