A cumulative dividend guarantees that you’ll get your dividend payment in the...
by Ashley GrasseHow to Calculate Dividend Growth Rate
Investing in dividend-paying stocks is a great way to add a steady and reliable income stream to your portfolio. While picking the right dividend stock can be tricky, some research and analysis can help ensure you’re adding a winner to your portfolio.
Dividend growth rate is one of the key metrics we can use to identify good dividend stocks. This metric helps us spot stocks with the potential for continued dividend payment and avoid stocks that might decrease dividends or stop paying altogether.
In this article, we’ll explain the basics of dividend growth rate, lay out a step-by-step process to calculate this metric, and break down some things to keep in mind when using this metric to analyze potential investments.
Dividend Growth Rate Explained
Most companies will reinvest profits early in the business life cycle to fuel growth. However, once the growth phase concludes and maturity is reached, companies begin to pay those profits out to shareholders in the form of a dividend payment.
The ex-dividend date is the date on which a stock’s price is adjusted to reflect the upcoming dividend payment. If you buy a stock on or after the ex-dividend date, you will not be entitled to receive the dividend payment.
Companies that regularly pay out dividends are typically seen as stable, financially healthy, and safe investments.
One way to analyze the likelihood of continuing or expanding dividend payments is by calculating dividend growth rate, which is a measure of how quickly a company’s dividends are increasing (or decreasing) over time.
A high dividend growth rate shows that the company is increasing profits while controlling expenses – a good sign of a financially healthy company.
How to Calculate Dividend Growth Rate
There are two different approaches to calculating the dividend growth rate of a stock: simple arithmetic mean and compounded mean.
Arithmetic Mean
Let’s look at how to calculate dividend growth rate using arithmetic mean (or simple average).
First, we need to find the dividend growth of each year we want to measure, which we can do by subtracting each year’s dividend from the year before.
Next, we add up all the differences, then divide by the total number of years measured.
This is the formula:
Arithmetic Mean = (Sum of Yearly Dividend Differences) / (Number of Years – 1)
Compounded Mean
For improved accuracy, we can calculate the dividend growth rate to include the effects of compounding returns, also called the geometric mean.
While the difference might be small, it could be a deciding factor when choosing between two comparable stocks.
This is the formula:
Compound Mean = [(Final Dividend / Initial Dividend) ^ (1 / (Number of Years – 1))] – 1
Practical Example
Now, let’s look at how to put these calculations into practice.
Here are the annual dividends of Company XYZ paid out over the last five years:
- Year 1: $1.02
- Year 2: $1.19
- Year 3: $1.28
- Year 4: $1.22
- Year 5: $1.46
Using arithmetic mean, we can calculate the dividend growth rate like this:
Arithmetic Mean = ((1.19 – 1.02) + (1.28 – 1.19) + (1.22 – 1.28) + (1.46 – 1.22)) / (5 – 1)
= (0.17 + 0.09 + (-0.06) + 0.24) / 4
= 0.44 / 4
= 0.11 or 11%
Using compound mean, we would calculate the dividend growth rate as follows:
Compound Mean = [(1.46 / 1.02) ^ (1 / (5 – 1))] – 1
= (1.43)^(1/4) – 1
= 1.10 – 1
= 0.10 or 10%
What is a Good Dividend Growth Rate?
We now know how to calculate the dividend growth rate, but what does it mean? How can it help us make better stock picks? Here are some things to keep in mind when using this metric.
Track Record Indicator
A positive dividend growth rate indicates a company’s ability to generate and distribute profits consistently.
Not only can the company make money, but they’re also able to maintain efficient business operations while increasing shareholder return.
For long-term investors, this is precisely the kind of opportunity we’re looking for. The stock may not be making headlines with huge price jumps, but the company will likely continue producing solid returns for the foreseeable future.
Subjective Metric
While dividend growth rate is a strong indicator, it doesn’t tell the whole story – no single indicator can.
Generally, a higher dividend growth rate is better (of course), but not if that number is being propped up artificially by cutting corners in other areas.
Be sure to analyze other factors about the company and the stock to decide whether it meets your risk tolerance and supports your long-term goals.
Don’t be blinded by one metric. If any number seems too good to be true, it probably is.
Check the Details
Always check the year-on-year details used to calculate the dividend growth rate. Averages can often be used to disguise volatility by producing smooth charts and pretty numbers.
Maybe the company paid out a big dividend one year but failed to maintain that performance – this won’t appear on the average.
As long-term investors, we seek consistency over years and decades, not big one-time payments.
Once you spot a stock with a reasonable dividend growth rate, always look into the details to be sure the rate means what you think it means.
Make Comparisons
We can use dividend growth rate to compare several similar stocks to see which one is a better buy.
This is especially useful if you’ve narrowed a list of potential stock buys down to a handful of suitable candidates. Dividend growth rate can help break the tie.
Don’t Forget Yield
Be sure to check the dividend yield. Dividend growth rate is just a percentage and doesn’t tell us anything about the actual size of the payouts. If a stock with a lower growth rate pays out larger dividends, it might be the better choice.
Time Frame
In general, dividend growth rate calculations are more accurate when measured over the longest possible time period.
However, you don’t want to include irrelevant years when the company might have been fundamentally different.
We’re trying to learn what the stock is doing now and what it might do next. Comparing current dividend payments with what happened ten years ago might not be helpful.
The time period measured is a vital judgment call you’ll have to make when performing your analysis.
Track Your Dividends
StockMarketEye, our comprehensive portfolio tracking software, provides several data points and reports to help you track dividend performance and payouts.
Specifically, our system tracks dividend yield, forward yield, payout ratio, yield on cost, and income received. You can also generate portfolio reports that track dividend payouts.
A Key Metric for Evaluating Potential Stock Investments
Dividend growth rate is a great way to evaluate the potential risk of stock investments, especially for long-term value investors.
A positive dividend growth rate usually indicates a stable, financially healthy company that can successfully generate profits while maintaining efficient business operations – a strong sign of a good investment opportunity.
But remember, dividend growth rate is not the whole story. Always apply as much technical and fundamental analysis as possible to a stock before buying.
Never make an investment decision based on a single metric.
