What is the 'Dividend Growth Rate'
The dividend growth rate is the annualized percentage rate of growth that a particular stock's dividend undergoes over a period of time. The time period included in the analysis can be of any interval desired, and is calculated by using the least squares method or by simply taking a simple annualized figure over the time period.
BREAKING DOWN 'Dividend Growth Rate'The dividend growth rate is necessary for using the dividend discount model, which is a security pricing model that assumes a stock's price is determined by the estimated future dividends, discounted by the excess of internal growth over the company's estimated dividend growth rate. A history of strong dividend growth could mean future dividend growth is likely, which can signal long-term profitability for a given company.
The dividend growth rate can be calculated linearly 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, the following formula is used:
Dividend Growth = Year X Dividend / (Year X - 1 Dividend) - 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, the following calculation can be used:
$1 x (1 + 3.56%) ^ 4 = $1.15
Growth Rate Used in Dividend Discount Model
The dividend discount model is used to value a company's stock based on the idea a stock is worth the sum of its future payments to shareholders, discounted back to the present day. The formula takes into account three variable to arrive at a current price, P. They are:
D1 = the value of next year's dividend
r = the cost of equity capital
g = the dividend growth rate
The dividend discount model's formula is:
P = D1 / (r - g)
In the above example, if it is assumed next year's dividend will be $1.18 and the cost of equity capital is 8%, the stock's current price per share is:
P = $1.18 / (8% - 3.56%) = $26.58