Overfitting

  

Categories: Metrics

Our cousin Jaime has put on a little weight recently, and as we sit across from him at a family dinner, we can’t help but notice that his favorite shirt is stretching apart at the seams trying to accommodate his expanding girth. We snicker and tell him it looks like his body is overfitting his clothes. He snickers back and tells us we used the word “overfitting” incorrectly.

He’s right, we did. “Overfitting” is actually what happens when we create a model based on data that can’t be extrapolated to the real world. It can’t predict; it can only draw conclusions based on the historical data upon which we built it. And if that data—our training data—isn’t reflective of reality, then our model won’t be, either. This usually happens as a result of one of two things: either we have way too many data parameters, or we have so few data points that our model treats the anomalies as part of the pattern it’s supposed to recognize and predict.

As an example, let’s get back to poor Jaime. Let’s say we’re trying to predict how many cans of Pepsi he’ll drink in a given day, so we keep a log for seven days. On Monday, Tuesday, and Thursday, he drank four cans. On Wednesday and Saturday, it was five. Friday was three, and Sunday was zero. Based solely on this data, our model might predict that Jaime won’t drink Pepsi on Sundays. In reality, though, he was sick that day and only drank green tea with honey and milk. That anomaly should not be a part of our Pepsi predictions, because it was just that: an anomaly. Our model overfits the data.

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Finance: What is the Dividend Discount M...2 Views

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Finance allah shmoop what is the dividend discount model Well

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it's a technique used to value companies or at least

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it wass in the stone age And yet in the

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nineteen fifties maybe which basically says that a company's value

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is fully contained in the cash dividends it distributes back

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to invest doors This model is only useful really for

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its historical relevance We we just don't use that much

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these days Yeah back in the old timey cave man

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days when there was essentially no research of real merit

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being done on the performance of investments of whatever flavor

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the dividend discount model was the best thing investors had

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to value an investment in a company And remember in

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those days companies paid rial dividends that were a meaningful

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percentage of the total value of the company Unless so

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a company pays a dollar a share this year in

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dividends Historically it's raised dividends at about three percent a

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year like paid a dollar last you'd expect two dollars

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three next year in dollars six and change the next

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so well The dividend discount model discounts backto present value

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And yes we have an opus on what president value

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Means but here's the logline definition present value of all

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future cash flows discounted for risk in time Back to

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cars Yeah that thing well a few odd things are

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worth noting in this horse and buggy era formula The

01:21

dividend discount model ignores the terminal or end value of

01:25

the company Like say twenty years from now the company

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is sold for cash The dividends are all that are

01:31

really focused on though in our model that seem strange

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to you Well maybe But let's say the discount rate

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is ten percent in the risk free rate is four

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percent for a total of fourteen percent a year discounted

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back to the present So doing the math just looking

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at the terminal value of say a hundred million bucks

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in a sale to be made twenty years from now

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Let's figure out what that's worth today Well you take

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the one point one four Put it to the twentieth

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power to reflect twenty years of discounted valuation compounding And

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you say one point one four forty twenty powers about

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thirteen point seven So to get the present value of

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one hundred million bucks twenty years from now using this

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discount rate Will you divide the hundred million by thirteen

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point seven and that means that the one hundred million

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dollars twenty years from now today is worth only seven

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point three million bucks And yeah that's ah big haircut

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kind of like this guy Well the formula focuses ah

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lot on near term dividend distribution and it's Really more

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interesting is a relic of original financial research in theory

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than anything directly useful today And if you find this

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