Understanding the Dividend Growth Rate
Dividend growth rate encapsulates the annualized average rate of increase in dividends that a company distributes to its shareholders. It’s a vital metric for investors using the dividend discount model (DDM) to ascertain the value of a stock, suggesting a company’s long-term profitability and stability.
What Is A Dividend?
A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits. When a company earns a profit or surplus, it can re-invest it in the business or distribute it to shareholders as a dividend.
How to Calculate the Dividend Growth Rate
Calculating the dividend growth rate can be done using a simple linear method or a more precise geometric mean. For the linear method:
List annual dividends over a period.
Calculate the growth from one year to the next using:
\[ \text{Dividend Growth Rate} = \left(\frac{\text{Dividend}{\text{Year } x}}{\text{Dividend}{\text{Year } (x-1)}} - 1\right) \times 100% \]
Example: Dividend Growth and Stock Valuation
For a practical example, let’s consider valuing a stock using the DDM. Assume the next year’s expected dividend is $1.18, and the cost of equity is 8%. With a dividend growth rate of 3.56%, the stock’s value would be calculated as:
\[ P = \frac{D_1}{r - g} = \frac{$1.18} {0.08 - 0.0356} = $26.58 \]
where \(P\) is the current stock price, \(D_1\) is the next year’s dividend, \(r\) the cost of equity, and \(g\) the growth rate.
What Is a Good Dividend Growth Rate?
A “good” dividend growth rate varies by investor expectations and market conditions. Typically, a steady rate that at least matches inflation ensures that the purchasing power of dividend earnings does not decline over time.
Dividend Yield vs. Dividend Growth Rate
Dividend Yield measures the ratio of a company’s annual dividends compared to its stock price. Conversely, Dividend Growth Rate reflects the annualized percentage growth in dividends paid by the company over time.
Related Terms
- Dividend Yield: The percentage of a company’s current stock price that it pays out in dividends each year.
- Dividend Discount Model (DDM): A valuation model that projects the present value of a stock based on its expected future dividends.
- Cost of Equity: The return that investors require for investing in a company’s equity; used as the discount rate in DDM.
- Compound Annual Growth Rate (CAGR): The mean annual growth rate of an investment over a specified time longer than one year.
Suggested Books for Further Studies
- “The Little Book of Common Sense Investing” by John C. Bogle – Focuses on the importance of understanding dividends in investment.
- “Dividends Still Don’t Lie” by Kelley Wright – A guide to understanding and investing in dividend-paying stocks.
- “Investing for Growth: How to make money by only buying the best companies in the world” by Terry Smith – Offers insights on how growth in dividends reflects company health and investment quality.
Exploring these resources can provide deeper insight into the critical role that dividend growth rates play in both company valuation and individual investment strategy, ensuring that your portfolio’s growth is aligned with your financial goals.
