Some investors may be wondering why stocks have not fallen more. The S&P 500 in the US has rebounded sharply in recent days and is now down by just 15 per cent year-to-date.

Yet US companies are expected to see their earnings decline much more than 15 per cent in the next few quarters. This will make their price-to-earnings ratios seem disproportionately higher than they were last year.

So why is there this gap between stock prices and earnings?

Discounted cash flow

The answer is that stock prices are not a reflection of a single year of earnings. Instead, it is the accumulation of the future free cash flow or earnings that a company will produce over its entire lifetime discounted back to today.

This economic concept is known as the discounted cash flow model. Investor Ben Carlson wrote a brilliant article on this recently.

For example, let's assume Company ABC is expected to earn $10 per share per year for the next 10 years. After discounting future cash flows back to the present day, at an 8 per cent discount rate, the company's shares are worth $67.10.

But let's assume that because of the Covid-19 crisis, ABC's earnings in the first year is wiped out. But it still can generate $10 a year in the remaining nine years after that. Using the discounted cash flow model, ABC's shares are still worth $57.84

Despite a 100 per cent decline in earnings in the coming year, ABC's share price is worth just 14 per cent less.

Other bad case scenarios

There are worse scenarios that can play out, but as long as a company's long term future cash flow or earnings remains somewhat stable, its share price should not fall as much as its near-term earnings.

For instance, let's assume that instead of earning $10 per share in the coming year, Company ABC now makes a loss of $10 per share.

But in year 2 onwards, business returns to normal and it can generate its usual $10 per share for the next nine years. In this case, Company ABC's shares are now worth $48.58, or 28 per cent less than before.

Let's make the situation worse. Let's assume Company ABC has a $10 per share loss in year 1 and has zero cash flow in year 2. Let's also assume that business only returns to normal in year 3. Its shares, in this case, are still worth $40.01, a 40 per cent decline.

History shows that stocks fall less than earnings

This is the reason why stocks tend to fall far less than short-term earnings declines. We can look at the Great Financial Crisis as a reference.

According to data from Nobel Prize-winning economist Robert Shiller, the S&P 500's earnings per share fell 77.5 per cent from $81.51 in 2007 to $18.31 in 2008.

But the price fell much less. The S&P 500 closed at 1520.71 in July 2007 and reached a low of 757.13 in March of 2009. That translated to a 50 per cent decline in stock prices.

Simply put, a 77.5 per cent decline in earnings translated to 'only' a 50 per cent decline in stock price.

Not only did the S&P 500's price fall much less than earnings, but the subsequent years have also shown that stocks may have fallen too low. Investors who bought in at the troughs of 2009 enjoyed better-than-normal returns over the next 10-plus years.

Assuming stock prices fall in tandem with one-year forward earnings is short-sighted and does not take into account all the future cash flows of a company.

Last words on the price-to-earnings ratio

I guess the takeaway for this post is that you should not be scared off stocks by the high price-to-earnings ratio of companies that will likely appear in the coming months (a high price-to-earnings ratio because of a large decline in earnings but less drastic fall in share price).

The fall in earnings, if only temporary, should logically only cause a small decline in the value of the company, especially if it can continue to make profits consistently over the extended future.

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It is natural that the PE ratio will be high if a company's earnings disappear in the coming year. But the disappearance of the earnings could be temporary. When Covid-19 blows over, some companies - not all - will see business resume.

For now, the PE ratio is a useless metric as earnings are battered down temporarily, making the figure appear disproportionately high. We should instead focus on normalised earnings and whether a company can continue to generate free cash flow in the future.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.