T-model

Key takeaways

T-model belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect T-model to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of T-model from memory before moving on to harder problems.

Reference excerpt

In finance, the T-model is a formula that states the returns earned by holders of a company's stock in terms of accounting variables obtainable from its financial statements. The T-model connects fundamentals with investment return, allowing an analyst to make projections of financial performance and turn those projections into a required return that can be used in investment selection.

Formula Mathematically the T-model is as follows:

T = g + R O E − g P B + Δ P B P B ( 1 + g ) {\displaystyle {\mathit {T}}={\mathit {g}}+{\frac {{\mathit {R}}OE-{\mathit {g}}}{{\mathit {P}}B}}+{\frac {\Delta PB}{PB}}{\mathit {(}}1+g)}

where T {\displaystyle T} = total return from the stock over a period (appreciation + "distribution yield" — see below);

g {\displaystyle g} = the growth rate of the company's book value during the period;

P B {\displaystyle PB} = the ratio of price / book value at the beginning of the period.

R O E {\displaystyle ROE} = the company's return on equity, i.e. earnings during the period / book value;

Derivation The return a shareholder receives from owning a stock is:

( 2 ) T = D P + Δ P P {\displaystyle (2){\mathit {T}}={\frac {\mathit {D}}{\mathit {P}}}+{\frac {\Delta P}{P}}}

Where P {\displaystyle {\mathit {P}}} = beginning stock price, Δ P {\displaystyle \Delta P} = price appreciation or decline, and D {\displaystyle {\mathit {D}}} = distributions, i.e. dividends plus or minus the cash effect of company share issuance/buybacks. Consider a company whose sales and profits are growing at rate g. The company funds its growth by investing in plant and equipment and working capital so that its asset base also grows at g, and debt/equity ratio is held constant, so that net worth grows at g. Then the amount of earnings retained for reinvestment will have to be gBV. After paying dividends, there may be an excess:

X C F = E − D i v − g B V {\displaystyle {\mathit {X}}CF={\mathit {E}}-{\mathit {D}}iv-{\mathit {g}}BV\,}

where XCF = excess cash flow, E = earnings, Div = dividends, and BV = book value. The company may have money left over after paying dividends and financing growth, or it may have a shortfall. In other words, XCF may be positive (company has money with which it can repurchase shares) or negative (company must issue shares). Assume that the company buys or sells shares in accordance with its XCF, and that a shareholder sells or buys enough shares to maintain her proportionate holding of the company's stock. Then the portion of total return due to distributions can be written as D i v P + X C F P {\displaystyle {\frac {{\mathit {D}}iv}{\mathit {P}}}+{\frac {{\mathit {X}}CF}{\mathit {P}}}} . Since R O E = E B V {\displaystyle {\mathit {R}}OE={\frac {\mathit {E}}{{\mathit {B}}V}}} and P B = P B V {\displaystyle {\mathit {P}}B={\frac {\mathit {P}}{{\mathit {B}}V}}} this simplifies to:

… excerpt ends here. Continue reading the full article.

Worked examples

Example 1 — a first encounter with T-model

Start with the simplest possible case. Write down what T-model claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to T-model before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about T-model ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of T-model

In research: T-model appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses T-model in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: T-model is common in secondary-school and first-year university syllabi. It links to neighbouring topics Financial models, Investment, so understanding it makes those chapters shorter.
In everyday life: Look for T-model outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

How to study T-model in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what T-model means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain T-model out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is T-model in simple terms?

In finance, the T-model is a formula that states the returns earned by holders of a company's stock in terms of accounting variables obtainable from its financial statements. The T-model connects fundamentals with investment return, allowing an analyst to make projections of financial performance a…

Why does T-model matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study T-model?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on T-model.