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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.

Calculation Example

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

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