Changes In Accounting Rules
Another reason the Shiller CAPE 10’s full-period mean may be an inappropriate benchmark is because accounting rules have changed, impacting how earnings (and thus P/E ratios) are determined. In 2001, the Financial Accounting Standards Board changed the rules regarding how goodwill is written off.
As a post on the blog Philosophical Economics explained: “In the old days, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental non-cash expense—over a forty-year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), all long-lived assets.”
While FAS 142 may have introduced a more accurate accounting method, it also created an inconsistency in earnings measurements. Present values end up looking much more expensive relative to past values than they actually are. And the difference is quite dramatic. Adjusting for the accounting change would put the CAPE 10 about 4 points lower.
Difference In Dividends
Still another reason not to rely on the Shiller CAPE 10’s long-term historical mean as a yardstick is that far fewer companies pay dividends now than in the past. For example, in their 2001 study, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Eugene Fama and Kenneth French found that the firms paying cash dividends fell from 67% in 1978 to 21% in 1999. This has resulted in the dividend payout ratio on the S&P 500 dropping from an average of 52% from 1954 through 1995 to just 34% from 1995 through 2015.
In theory, higher retention of earnings should result in faster growth of earnings as firms reinvest that retained capital. That has been the case for this particular period; from 1954 to 1995, the growth rate in real earnings per share averaged 1.72%, and from 1995 to 2015, it averaged 4.9%.
As the post on Philosophical Economics explained, to make comparisons between present and past values of the Shiller CAPE 10, any differences in payout ratios must be normalized. The adjustment between the 52% payout ratio (the average from 1954 through 1995) and the 34% payout ratio (the average from 1995 through 2015) corresponds to approximately a one-point difference on the Shiller CAPE 10.
There’s yet another reason the long-term mean of the CAPE 10 might be misleading. Investors demand a premium for taking liquidity risk (less-liquid investments tend to outperform more liquid investments). All else equal, investors prefer greater liquidity. Thus, they demand a risk premium to hold less-liquid assets. Over time, the cost of liquidity, in the form of bid/offer spreads, has decreased. There are several reasons for this, including the decimalization of stock prices and the provision of additional liquidity by high-frequency traders.