Unleashing the Power of Dividend Growth: Your Guide to Profitable Stock Investments
The dividend growth rate is the annualized percentage rate of growth that a particular stock’s dividend undergoes over a period of time. Many mature companies seek to increase the dividends paid to their investors on a regular basis. Understanding the dividend growth rate is crucial for stock valuation models known as dividend discount models.
Key Takeaways
- Dividend Growth: Calculates the annualized average rate of increase in the dividends paid by a company.
- Valuation Necessity: Calculating the dividend growth rate is essential for using a dividend discount model to value stocks.
- Profitability Indicator: A history of strong dividend growth may indicate future growth, signaling long-term profitability.
Understanding the Dividend Growth Rate
Being able to calculate the dividend growth rate is essential for using the dividend discount model, a type of security-pricing model. This model assumes that the estimated future dividends, discounted by the excess of internal growth over the company’s estimated dividend growth rate, determine a given stock’s price.
If the dividend discount model results in a higher number than the current price of a company’s shares, the stock is considered undervalued. Investors using this model believe that by estimating the expected future cash flow, they can find the intrinsic value of a specific stock.
A history of strong dividend growth could signal long-term profitability for a given company. Investors can calculate the dividend growth rate for any desired time interval, employing methods like the least squares method or a simple annualized figure.
How to Calculate the Dividend Growth Rate
An investor can use either an average or geometric method for more precision. An example using the linear method is shown below:
A company’s dividend payments over the last five years were:
- Year 1 = $1.00
- Year 2 = $1.05
- Year 3 = $1.07
- Year 4 = $1.11
- Year 5 = $1.15
To calculate the growth from one year to the next, use the formula:
Dividend Growth = (Dividend-Year X) / (Dividend-Year(X-1)) - 1
In this example, the growth rates are:
- Year 1 Growth Rate = N/A
- Year 2 Growth Rate = $1.05 / $1.00 - 1 = 5%
- Year 3 Growth Rate = $1.07 / $1.05 - 1 = 1.9%
- Year 4 Growth Rate = $1.11 / $1.07 - 1 = 3.74%
- Year 5 Growth Rate = $1.15 / $1.11 - 1 = 3.6%
The average of these four annual growth rates is 3.56%. Verify this calculation using:.
$1 x (1 + 3.56%)^4 = $1.15
Example: Dividend Growth and Stock Valuation
To value a company’s stock, an individual can use the dividend discount model (DDM). This model is based on the idea that a stock’s worth is the sum of its future payments to shareholders, discounted back to the present day.
The simplest dividend discount model, known as the Gordon Growth Model (GGM), uses the formula:
P = D1 / (r - g)
Where:
- P: Current stock price
- g: Constant growth rate expected for dividends, in perpetuity
- r: Constant cost of equity capital for the company (or rate of return)
- D1: Value of next year’s dividends
If we assume next year’s dividend will be $1.18 and the cost of equity capital is 8%, the stock’s current price calculates as follows:
P = $1.18 / (8% - 3.56%) = $26.58
What Is a Good Dividend Growth Rate?
A good dividend growth rate varies for each investor. Generally, investors favor companies offering 10 consecutive years of annual dividend increases, paired with a 10-year dividend per share compound annual growth rate (CAGR) of 5%.
Difference Between Dividend Yield and Dividend Growth
Dividend Yield: The amount a company pays out in dividends compared to its stock price.
Dividend Growth: The increase in the value of dividends a company pays out over time.
Do Dividends Grow Every Year?
Whether dividends grow every year depends on the company. Generally, well-established companies aim to ensure dividends grow annually, though it is not guaranteed.
The Bottom Line
Dividends can significantly enhance an investor’s portfolio, providing a regular income stream, especially when stock appreciation is minimal. Understanding how a company maintains its dividend payments and the history of its dividend growth can help investors make informed decisions. Calculating the dividend growth rate is essential in guiding these investment choices.
Related Terms: Dividend Discount Model, Gordon Growth Model, Dividend Yield, Stock Valuation.
