The dividend growth rate of a stock is the percentage of annual growth of its dividends that it has gone over a period of time. This growth rate can be a decisive factor for investors looking to invest in stocks.
Companies try to increase the dividend they pay to investors annually to keep their stockholders satisfied.
Furthermore, the dividend growth rate can be used in models such as the Dividend Discount Model (DDM) to determine the fair value of a stock.
What is a Dividend?
When a company makes profits or earnings, they may choose to give a portion of the earnings to their stockholders based on their percentage of stockholding.
This portion of earnings paid to stockholders by the company is called dividends. The decision to pay stockholders dividends is generally made by the Board of Directors and approved by the stockholders.
Dividends are generally paid in cash to the stockholders holding the stock of the company on or by the ex-dividend date. However, dividends can also be paid to stockholders in shares, for example, using bonus issues.
In addition, some companies may not pay dividends at all and choose to retain all the earnings made. In this case, investors can make a profit by the appreciation of the price of the stock due to the retained earnings.
2 Importance of Dividends to Key Stakeholders
Dividends are important for both stockholders and companies.
1) For Stockholders
Some investors invest in the stocks of a company for long-term purposes. During this time, investors don’t sell their stocks. This means during this time, there is no other source of income for the investor.
In addition, some investors only invest in a company to receive dividends. For stockholders, dividends are a regular source of income without having to sell their shares.
2) For Companies
Companies need to pay their stockholders regular returns on their investments. This can be achieved by giving them dividends.
When a company pays its stockholders dividends, it helps the company maintain the trust of its stockholders and also maintain a good relationship with them.
Oftentimes, when companies decide not to pay dividends to their stockholders, without any reason, their stock price drop in the stock market.
Dividend Growth Rate and Usage for Investors
One of the tools available for investors to calculate the fair value of a stock is the Dividend Discount Model.
This tool assumes that the present value of the stock, or its fair value, is equal to the total sum of all the dividends the investor will receive in the future, discounted to its present value.
To calculate a company’s discounted estimated future dividends, it is important to find the dividend growth rate for the company.
Using the dividend discount model, investors can calculate the company’s expected future cash flows, which will be in the form of dividends.
If the result obtained from the dividend discount model is higher than the current price of the company’s stock in the market, the stock is deemed undervalued.
In case the current price of the stock is higher in the market compared to the result of the dividend discount model, then the stock is deemed to be overvalued.
Investors can also use the dividend growth rate of a company by itself. Investors can determine whether a company’s dividends will grow in the future using trend analysis.
If the dividend growth rate of a company has increased for the past few years, it is likely that it will increase in the current year as well.
Calculating Dividend Growth Rate
The dividend growth rate of a company can be calculated using its historical data. An investor can calculate the dividend growth rate of a company over a year using the following formula:
Dividend Growth = (Dividend for the latest year / Dividend for the year before the latest year) – 1
For example, suppose a company ABC Co. paid the following dividends for the years:
For the above example, the dividend growth for 2016 will be 11% (($11.10/$10.00) – 1).
The dividend growth percentages will be 12.6%, 6%, and 13.6% for 2017, 2018, and 2019 respectively.
To calculate the total growth from 2016 to 2019, investors can take the total average of the growth over the years.
Therefore, the total growth from 2016 to 2019 will be 10.8% ((11% + 12.6% + 6% + 13.6%) / 4). The 10.8% is called a forward-looking growth rate and can be used to forecast future dividends.
The expected dividend for the stock for 2020 will be $16.68 ($15.05 x (1 + 10.8%)).
The above example assumes dividend has grown over the years. Sometimes, stocks may also experience zero dividend growth (i.e. the company pays the same dividend as the previous year) or a dividend cut (i.e. the company pays a lower dividend than it paid last year).
The reasons for zero dividend growth or dividend cut are often poor performance. Sometimes, however, companies may prefer to retain profits to pay them out as dividends due to various reasons.
Decision-making for Investors
As demonstrated, investors can use dividend growth to estimate not only future dividends but also as a decision-making tool.
When choosing between stocks to invest in, investors can choose stocks with steady growth.
A company that has had a steady dividend growth rate in the past will likely grow in the future as well.
Steady dividend growth may, however, create a negative expectation from the company. A company with a good dividend growth rate in the past may have to pay its stockholders dividends even in times when the company needs to retain the earnings, due to the expectations they have raised in the past.
Furthermore, in times of downfall or bad results, the company may still have to pay its stockholders, leading to the stock’s market value dropping.
Dividends growth rate or any other tools that rely on dividends are great tools on which investors base their decisions.
However, investors should still be aware that these tools rely on historical data which is obtained from a company’s financial statements.
Investors looking to take full advantage of these tools should try and obtain the latest data from sources other than the company’s financial statements, such as press releases, quarterly reports, etc.
A dividend growth rate can help investors greatly when evaluating stocks. It can be further used in tools such as the Dividend Discount Model and its variants to evaluate a company’s stocks further.
However, there are some factors that investors should consider before making decisions based on dividends.