T-model
connects fundamentals with investment return
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.
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