The dividend growth rate is the annualized percentage rate of growth that a specific stock’s dividend experiences over a period of time. It is expressed as a rate per year. A significant number of established businesses consistently work toward the goal of boosting the dividends that they hand out to their shareholders. For stock valuation models also known as dividend discount models, having accurate knowledge of the dividend growth rate is a crucial input.
Understanding the Dividend Growth Rate
The dividend discount model requires the ability to determine the dividend growth rate. A sort of security-pricing model is the dividend discount model. The dividend discount model implies that a given stock’s price is determined by the expected future dividends—discounted by the excess of internal growth over the company’s estimated dividend growth rate. If the dividend discount model process yields a number greater than the current share price of a company, the model judges the stock to be undervalued. Dividend discount model investors believe that by assessing the expected value of future cash flows, they can determine the intrinsic value of a certain stock.
A history of substantial dividend growth may indicate that further dividend increase is expected, which can indicate a company’s long-term prosperity. When calculating the dividend growth rate, an investor can use any time interval they like. They can also use the least squares method or simply take a simple annualized figure throughout the time period to calculate the dividend growth rate.
Calculate the Dividend Growth Rat
An investor can calculate the dividend growth rate by taking an average, or geometrically for more precision. As an example of the linear method, consider the following.
A company’s dividend payments to its shareholders 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 following formula:
In the above 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%. To confirm this is correct, use the following calculation:
$1 x (1 + 3.56%)4 = $1.15
Example: Dividend Growth and Stock Valuation
Individuals can use the dividend discount model to determine the worth of a company’s stock (DDM). The dividend discount model holds that a stock is worth the sum of its future dividend payments to owners, discounted back to the present.
The simplest dividend discount model, known as the Gordon Growth Model (GGM)’s formula is:
In the above example, if we assume next year’s dividend will be $1.18 and the cost of equity capital is 8%, the stock’s current price per share calculates as follows:
P = $1.18 / (8% – 3.56%) = $26.58
Summery
- Dividend growth is the annualized average rate of increase in a company’s dividend payments.
- When utilizing a dividend discount model to value equities, the dividend growth rate must be calculated.
- A track record of substantial dividend growth may indicate that future dividend increase is expected, which can indicate long-term profitability.