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.
Related or Semi-related Video
Finance: What is the Dividend Discount M...2 Views
Finance allah shmoop what is the dividend discount model Well
it's a technique used to value companies or at least
it wass in the stone age And yet in the
nineteen fifties maybe which basically says that a company's value
is fully contained in the cash dividends it distributes back
to invest doors This model is only useful really for
its historical relevance We we just don't use that much
these days Yeah back in the old timey cave man
days when there was essentially no research of real merit
being done on the performance of investments of whatever flavor
the dividend discount model was the best thing investors had
to value an investment in a company And remember in
those days companies paid rial dividends that were a meaningful
percentage of the total value of the company Unless so
a company pays a dollar a share this year in
dividends Historically it's raised dividends at about three percent a
year like paid a dollar last you'd expect two dollars
three next year in dollars six and change the next
so well The dividend discount model discounts backto present value
And yes we have an opus on what president value
Means but here's the logline definition present value of all
future cash flows discounted for risk in time Back to
cars Yeah that thing well a few odd things are
worth noting in this horse and buggy era formula The
dividend discount model ignores the terminal or end value of
the company Like say twenty years from now the company
is sold for cash The dividends are all that are
really focused on though in our model that seem strange
to you Well maybe But let's say the discount rate
is ten percent in the risk free rate is four
percent for a total of fourteen percent a year discounted
back to the present So doing the math just looking
at the terminal value of say a hundred million bucks
in a sale to be made twenty years from now
Let's figure out what that's worth today Well you take
the one point one four Put it to the twentieth
power to reflect twenty years of discounted valuation compounding And
you say one point one four forty twenty powers about
thirteen point seven So to get the present value of
one hundred million bucks twenty years from now using this
discount rate Will you divide the hundred million by thirteen
point seven and that means that the one hundred million
dollars twenty years from now today is worth only seven
point three million bucks And yeah that's ah big haircut
kind of like this guy Well the formula focuses ah
lot on near term dividend distribution and it's Really more
interesting is a relic of original financial research in theory
than anything directly useful today And if you find this
interesting while then we may have a gig for you
here at shmoop finance central Yeah come on down We 00:02:39.715 --> [endTime] need writers good ones not like me
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