From Philosophical Economics:
A common criticism of Professor Robert Shiller’s famous CAPE measure
of stock market valuation is that it fails to correct for the effects of
secular changes in the dividend payout ratio. Dividend payout ratios
for U.S. companies are lower now than they used to be, with a greater
share of U.S. corporate profit going to reinvestment. For this reason,
earnings per share (EPS) tends to grow faster than it did in prior eras.
But faster EPS growth pushes up the value of the Shiller CAPE, all
else equal. Distortions therefore emerge in the comparison between
present values of the measure and past values.
To give credit where it’s due, the first people to point out this
effect–at least as far as I know–were Professor Jeremy Siegel of Wharton
Business School and his former student, David Bianco of Deutsche Bank.
Siegel, in specific, wrote about the problem as far back as late 2008,
during the depths of the financial crisis, when the Shiller CAPE was
steering investors away from a market that he considered to be extremely
cheap (see “Jeremy Siegel on Why Equities are Dirt Cheap”, November 18,
2008, link here).
In a piece from 2013, I attempted to demonstrate the effect with two tables, shown below:
The tables portray the 10 year earnings trajectories and Shiller CAPE
ratios of two identical companies that generate identical profits and
that sell at identical trailing-twelve-month (ttm) P/E valuations. The
first company, shown in the first table, pays out 75% of its profit in dividends and reinvests the other 25% into
growth (in this case, share buybacks that grow the EPS by shrinking the
S). The second company, shown in the second table, pays out 25% of its profit in dividends, and reinvests the other 75% into growth....MORE
