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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.

BREAKING DOWN 'Dividend Growth Rate'

The dividend growth rate is necessary for using the dividend discount model. The dividend discount model is a type of security pricing model. The pricing 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 procedure results in a higher number than the current price of a company’s shares, the model considers the stock undervalued. Those who use the dividend discount model believe that by estimating the expected value of cash flow in the future, they can find the intrinsic value of a  specific stock.

A history of strong dividend growth could mean future dividend growth is likely, which can signal long-term profitability for a given company. When an individual calculates the dividend growth rate, they can use any interval of time they wish. 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.

How to Calculate the Dividend Growth Rate

An individual calculates the dividend growth rate 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, use the following formula:

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, use the following calculation:

$1 x (1 + 3.56%) ^ 4 = $1.15

Growth Rate Used in Dividend Discount Model

To value a company’s stock, an individual can use the dividend discount model. 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 formula takes into account three variables 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 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 calculates as follows:

P = $1.18 / (8% - 3.56%) = $26.58.

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