DIVIDEND GROWTH RATE
What is Dividend Growth Rate (DGR) ?
The Dividend Growth Rate (DGR) is the growth rate of a company’s dividend achieved during a specific time of period, measured in percentage. Ideally, the DGR is calculated on annual basis however it can be announced every quarter along with the financial earnings.
The dividend growth rate is important since it can determine the stability of a company in terms of profitability. Dividends are paid off from the company’s earnings to its shareholders, and analysts can assess and evaluate its ability to keep paying the dividends while comparing its profitability and revenues to DGR.
How to calculate the Dividend Growth Rate?
The simplest way to calculate the dividend growth rate is to put each year’s dividends into the following formula:
Dividend Growth Rate = D2/D1-1
So, Let’s assume that XYZ company paid its shareholders dividends of $2.40 in 2020 (year one) and $2.60 in 2021 (year two). The equation will be as follows:
Dividend Growth Rate = 2.60/2.40-1
= 0.0833 or 8.33%
The Dividend Discount Model
The dividend growth rate can be used to calculate an asset’s price, as an essential variable in the Dividend Discount Model (DDM).
The DDM is based on the idea that the company’s current stock price is equal to the net present value of the company’s future dividends. Thus, the formula is the following:
P0= the current company’s stock price per share
D1= the next year dividends
r= the company’s cost of equity
g= the dividend growth rate
In order to calculate the DDM we first need determine the forward-looking growth rate.
Let’s assume that XYZ company has paid the following dividends in order to calculate the dividend growth rate:
Dividend Growth Rate
How to calculate the forward-looking growth rates:
- A) Use historical dividend growth rates so we can calculate the arithmetic average:
B) Use the company’s historical dividend growth rate to calculate the compound annual growth rate (CAGR):
CAGR= (1.25/1)^(1/5)-1=0.0456 or 4.56%
2. Find the dividend growth rate prevalent in the industry that the company is operating.
Imagine that the average DGR in the industry is 6%. Use this rate for XYZ company.
- Calculate the sustainable growth rate.
The sustainable growth rate is the maximum growth rate that a company can sustain without external financing. The sustainable growth rate can be found using the following formula:
Sustanable growth rate=ROE x (1-Dividend Payout ratio)
If XYZ has a ROE of 20% and its dividend payout ration is 45% the equation will be:
20% x (1- 45%) = 11%
Why is it important to know the DGR
By calculating the dividend growth rate of a company we can then calculate the dividend discount model. As mentioned above the DDM is a type of security pricing. DDM takes into account the estimated future dividends which are discounted by the excess of internal growth of the company’s estimated dividend growth rate. Therefore, you find the stock’s price. If the DDM results in a higher number than the price per share it is a sign that the stock is currently being undervalued.
Investors who use the DDM method believe that the estimated future cash flow of the company can actually find the intrinsic value of a stock.
If the calculations lead to an undervalue stock, investors will consider this as a buy signal and vice versa.
As you already know in order to achieve the maximum return on a specific stock, the ideal is to buy low and sell high but most importantly it is to identify undervalued stocks that are being traded less than its real value (that should be higher). Thus, you are buying at a “discount”.