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Understanding Dividend Growth Rate
Let me explain what the dividend growth rate really means for you as an investor. It's the annualized percentage rate at which a stock's dividend increases over a specific period. Many established companies aim to boost the dividends they pay out to shareholders regularly, and knowing this rate is essential if you're using dividend discount models to value stocks.
Key Takeaways
Dividend growth tracks the annualized average increase in a company's dividend payments. You need to calculate it to apply the dividend discount model for stock valuation. If a company has a solid history of dividend growth, it's a good sign that future growth might continue, pointing to long-term profitability.
Why the Dividend Growth Rate Matters
You have to be able to calculate the dividend growth rate to use the dividend discount model effectively. This model is a way to price securities by assuming that a stock's value comes from its estimated future dividends, discounted by the difference between the company's internal growth and its dividend growth rate. If the model's output is higher than the current share price, the stock is undervalued according to this approach. Investors like you who rely on this model estimate future cash flows to find a stock's intrinsic value. A track record of strong dividend growth suggests that more is likely ahead, indicating solid long-term profits. You can use any time interval for your calculations, whether it's the least squares method or a straightforward annualized average.
How to Calculate the Dividend Growth Rate
You can figure out the dividend growth rate by averaging the yearly increases or using a geometric approach for better accuracy. Take this linear example: suppose a company's dividends over five years were $1.00 in year 1, $1.05 in year 2, $1.07 in year 3, $1.11 in year 4, and $1.15 in year 5. The formula for year-over-year growth is Dividend Growth = Dividend Year X / Dividend Year (X-1) - 1. That gives you rates of 5% for year 2, 1.9% for year 3, 3.74% for year 4, and 3.6% for year 5. Averaging those comes to 3.56%. To verify, $1 multiplied by (1 + 3.56%) raised to the power of 4 equals $1.15, which matches.
Example: Dividend Growth and Stock Valuation
Let's see how this plays into valuing a stock using the dividend discount model (DDM). The core idea is that a stock's worth is the present value of its future dividend payments to shareholders. The simplest version, the Gordon Growth Model (GGM), uses this formula: P = D1 / (r - g), where P is the current stock price, g is the constant expected dividend growth rate forever, r is the constant cost of equity (or required return), and D1 is next year's dividend. Using our earlier example, if next year's dividend is $1.18 and the cost of equity is 8%, then P = $1.18 / (8% - 3.56%) = $26.58.
What Is a Good Dividend Growth Rate?
What's considered a good dividend growth rate depends on your investment goals, but generally, look for companies with at least 10 years of consecutive annual increases and a 10-year compound annual growth rate (CAGR) of 5% or more.
Dividend Yield vs. Dividend Growth
Don't confuse dividend yield with dividend growth. Yield is the dividend amount relative to the stock price, while growth is how much those dividends increase over time.
Do Dividends Grow Every Year?
It varies by company. Established firms that pay dividends usually aim to increase them annually, but it's not a guarantee—growth depends on the company's performance and decisions.
The Bottom Line
Dividends can significantly enhance your portfolio by providing steady income, especially if the stock isn't appreciating much. By understanding a company's approach to dividends and calculating the growth rate, you can make smarter investment choices. This metric is a practical tool for evaluating potential returns.
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