Dividend Growth Rate

The Dividend growth rate measures the increase in dividends over time. As a result, investors often include stocks with very high upside potential in their portfolios.

Some indicators are often linked to the company's growth rate, like:

• Sales growth 
• Profit growth 
• Operational performance 
• Cash flow stability 

When a company makes sufficient profits to cover its expenses and maintains a proportion as reserves, they often announce dividends as a reward for the shareholders for holding their stock. It is the most straightforward technique to earn additional income in the long term. 

Dividends can be paid annually or in the interim. Some companies establish themselves as consistent dividend payers, while others have never paid a dividend to their investors. 

Usually, it is termed that a company that pays dividends has a slow growth rate, while those that do not announce any dividends have a higher growth rate. This is because the dividends are paid from the retained earnings that can be used for investment purposes. 

Analysts use a tool for companies that pay dividends constantly to identify how the dividend amount has evolved. The dividend growth rate estimates how much the dividend has grown over time. 

Therefore, investors can develop investment strategies for long-term returns with a sound understanding of the dividend growth rate.

Dividend Growth Rate Explained

Dividend Growth Rate is a stock dividend growth over time. It is measured as an annual percentage rate (APY). Since the dividend payouts affect the stock price, the dividend growth rate is an essential indicator for stock valuation.

If an investor sells their shares at a high price while pocketing capital gains, they lose their right to the future dividends announced by the company. This is because the share price represents the present value of all future dividend payments. 

The dividends are paid out from a company's earnings. They can be paid in cash, stock, strip, or property. Stock dividends involve issuing additional shares to the shareholders, whereas cash dividends are paid in cash.

The growth rate is measured based on the frequency of the dividends declared by a company. For example, if a company only declares a dividend once a year, the growth rate is calculated for an annual term. 

On the other hand, if a company announces dividends in the interim, a quarterly calculation should be undertaken. For example, a company announces a final dividend in the annual report and interim dividends in the quarterly reports. 

Companies that can sustain a high dividend growth rate are likely to remain profitable in the future. In addition, they exhibit stable cash flow and earnings, indicating long-term growth prospects.

Furthermore, if a company can generate a greater yearly dividend rate due to its operations, it suggests that there can be higher dividend growth in the future.

The dividend growth rate is especially used in the Dividend Discount Model (DDM) or the Gordon Growth Model. The DDM is a tool that quantitatively assesses the current price of a stock to be the sum of the present value of all future dividends that a company would declare. 

The data required to calculate the model are:

• The stock price 
• Cost of equity 
• Dividend for the next year 
• The growth rate 

It is also possible to estimate the dividend growth rate through reverse engineering. For example, if an investor has the first three values present, they can deduce the growth rate easily using the formula.

Analysts can use this tool to evaluate whether the stock is undervalued or overvalued. 

A stock is undervalued if it generates a result that exceeds the current stock price of the stock. The share price appears below the company's intrinsic value, creating an opportunity for upward movement in the future. 

Investors may see this as an opportunity to purchase the stock at a discounted price.

Conversely, if the DDM calculation yields a result lower than the current stock price, it suggests that the stock is overvalued. The stock's market price is higher than its intrinsic value, indicating that it may be priced too optimistically. 

In such situations, the stock price may adjust downward to align with its intrinsic value.

The DDM serves as a tool to provide insights into whether a stock is trading at a price that is justified by its expected future dividends. However, it's important to note that other factors and valuation methods should be considered in conjunction with the DDM to comprehensively assess a stock's value.

Why Invest Using a Dividend Growth Rate?

As mentioned earlier, the dividend growth rate is one tool for predicting a company's long-term profitability. To accurately evaluate a company's financial strength, it should be used in conjunction with other metrics such as cash flow projections, trend analysis, and financial ratios.

The growth rate is used to compute the Dividend Discount Model that indicates the intrinsic value of a share. Investors can use this tool to develop their investment strategies by evaluating the company’s financial strengths.  

Companies with a history of increasing their dividend payouts annually can be included in an investor's portfolio because they are reliable, stable, and less volatile investments.

The companies that have consistently paid out dividends are included in the S&P 500 Dividend Aristocrats Index. To be included in this index, a company must be:

• A part of the S&P 500 companies,
• Increased their dividend growth rate for 25 consecutive years, 
• Maintain a minimum market capitalization of $3 billion, and
• Maintain at least $5 million as an average trading volume for the past three months. 

A lesser-known group of consistent dividend payers is known as the dividend kings. The dividend kings are the exclusive set of companies that have kept and advanced their dividend-paying status for 50 consecutive years.

Fewer companies qualify as dividend kings due to their requirements. Nonetheless, an investor can attain long-term incentives by owning such stocks. 

Investors can gain more from a portfolio that includes companies with faster dividend growth than stocks with a slower rate. 

In financial markets, stocks offering a higher dividend growth rate often experience increased demand. This increased demand can benefit the company by providing additional capital that can be used for expansion opportunities.

Types of Dividend Growth Rates

If an investor attempts to compute a growth rate, they may find that this rate can fall under one of the following categories.

1. Zero Growth

This rate is subjected to companies that consistently pay a constant dividend stream indefinitely without any increase over time. In the Dividend Discount Model (DDM), the concept of growth (g) is not applicable in this case.

To calculate the value of the stock, the constant dividend is treated as perpetuity and should only be divided by the cost of equity, or r. 

For example, if a company pays $10 as a dividend indefinitely and has a 7% cost of equity. The intrinsic share price would be $143 ($10 / 7%). 

2. Constant Growth 

This rate is subject to companies that grow the number of dividends paid at a fixed or constant rate, g. However, the cost of equity will be higher than the growth rate (r > g). 

To find the intrinsic share price, the formula used is

P = D₁ / (r - g) 

Where,

• P = stock price
• D₁ = dividend at year 1 (next year)
• r = cost of equity
• g = dividend growth rate, constant

More commonly, this type of growth rate is used in the Gordon Growth Model. An example of this type of rate is discussed later in this article. 

3. Variable Growth 

This rate applies to companies with different dividend growth rates per year. It accurately represents the dividend growth valuation. It includes the effects of changing expectations and the market situation.

The variable growth rate is used in the multi-step dividend discount model. It allocates g₁ to the initial growth rate and g₂ to the subsequent growth rates. The initial growth rate is usually higher, while the subsequent ones are steadier. 

For example, the company’s dividend could grow by 7% in each of the first five years. Following the initial five years, the compensation stabilizes at a rate of 4%.

Calculating The Dividend Growth Rate

Investors must estimate the growth rate, g, to conduct a Dividend Growth Model. The Dividend Growth Model is one way to calculate the cost of equity by considering the dividends.

The cost of equity is a term that describes the return that an investor may reasonably expect for the stock. There is also an alternative method that can be used, which is the Capital Asset Pricing Model (CAPM).

The only factor used in determining the growth rate is the recorded dividends that the company has announced in the past years. The dividend horizon is dependable on investor preferences.

After the dividend data is extracted from the company's profile, the investor must find its percentage period-to-period change. We can determine this using the formula below. 

Change = (New dividend - old dividend) / Old dividend

There is a negative growth or a decrease in the dividend payout when the newly declared dividend is below the old dividend. 

Alternatively, investors can refer to data published by analysts, including predicted future or historical growth rates. These external sources can provide additional insights into the dividend growth prospects of a company.

Constant Dividend Growth 

Suppose an investor chooses a stock that has provided dividends for the past ten years. The investor focuses on the 5-year horizon and wants to estimate the constant growth rate based on the annual dividends announced.

The dividends are declared as follows:

The percentage year-on-year change is calculated as follows:

When we average the percentage change, the result is 19%, the estimated arithmetic constant growth rate.

g = (25% + 40% - 14% + 25%) / 4 = 19%

Alternatively, we can estimate the compounded growth rate using the formula below. 

Compounded Growth Rate = (D_n  /  D₀) ^ 1/n - 1

Where,

• D_n is the last dividend declared, 
• D₀ is the initial dividend declared, and
• n is the number of years. 

Compounded growth rate = (3.75 / 2) ^ ⅕ - 1 = 13.4%

Now that we have learned to estimate a growth rate, let us understand how to calculate a basic Gordon Growth Model.

P = D₁  / (r - g)

Where,  

• P = stock price,
• D₁ = dividend at year 1 (next year),
• r = cost of equity,
• g = dividend growth rate, constant 

Assume that the company has announced a dividend payout for the next year for $5. They have a hypothetical cost of equity equivalent to 5% and a perpetual dividend growth rate of 2.5%. We can estimate that the stock price should be $200. 

P = 5 / (0.05 - 0.0025) = $200

Investors that hold the stock at a price below $200 should maintain their positions. While investors with a purchase price above $200 should trade with caution. 

The growth rate can be deduced from the equation when all other factors are present. It can be called the implied growth rate. 

200 = 5 / (0.05 - g)

 g = 0.0025 or 25%

Researched and authored by Astrid Dsouza | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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