Calculating Dividend Growth Rate: Definition, Formula, and Example

The dividend growth rate is the annualized percentage rate of growth that tracks how a company’s dividend payments increase over time. The dividend growth rates aid investors in evaluating stock value through dividend discount models. Based on historical data, dividend growth is a predictor of future growth and profitability.

Many mature companies seek to increase the dividends paid to their investors on a regular basis. Knowing the dividend growth rate is a key input for stock valuation models known as dividend discount models.

Break Down of Dividend Growth Rate Fundamentals

Being able to calculate the dividend growth rate is necessary for using the dividend discount model. The dividend discount model is a type of security-pricing model. The dividend discount 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 shows a higher value than the current share price, the stock is considered undervalued. Investors using the dividend discount model estimate future cash flow to find a stock’s intrinsic value.

A history of strong dividend growth could mean future dividend growth is likely, which can signal long-term profitability for a given company. Investors can choose any time period to calculate the dividend growth rate. They may also calculate the dividend growth rate using the least squares method or by simply taking a simple annualized figure over the time period.

Step-by-Step Guide to Calculating the Dividend Growth Rate

Investors can calculate the dividend growth rate using an average or a geometric method for more accuracy. 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:

Dividend Growth= Dividend_YearX /(Dividend_{Year(X – 1)}) – 1

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 of Dividend Growth Rate Application in Stock Valuation

To value a company’s stock, an individual can use the dividend discount model (DDM). The dividend discount model is based on the idea that a stock is worth 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)’s formula is:

$\begin{aligned} &P = \frac{ D_1 }{ r – g } \\ &\textbf{where:} \\ &P = \text{Current stock price} \\ &g = \text{Constant growth rate expected for} \\ &\text{dividends, in perpetuity} \\ &r = \text{Constant cost of equity capital for the} \\ &\text{company (or rate of return)} \\ &D_1 = \text{Value of next year’s dividends} \\ \end{aligned}$​P=r−gD1​​where:P=Current stock priceg=Constant growth rate expected fordividends, in perpetuityr=Constant cost of equity capital for thecompany (or rate of return)D1​=Value of next year’s dividends​

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 is calculated as follows:

P = $1.18 / (8% – 3.56%) = $26.58.

The Bottom Line

The dividend growth rate is a tool for assessing a company’s potential profitability and investment value. It’s important for investors to understand a company’s dividend payment philosophy and history for making informed investment decisions.

Consistent dividend growth can indicate long-term profitability, which is a favorable attribute for investors seeking reliable returns. Use of the dividend discount model (DDM) and related calculations like the Gordon Growth Model to find a company’s intrinsic stock value. While dividends offer a source of income, investors should evaluate overall stock performance and growth potential.