How to calculate dividend growth rate

Learning the fundamentals of investing introduces you to crucial concepts like a dividend, which is a portion of a company’s profits that is paid out to its shareholders as a reward for investing in the company’s stock. Imagine owning a slice of your favorite tech giant or clothing brand and getting a small share of their profits just because you hold their stock. That's why companies pay out dividends — to attract new investors and keep them happy! 

But how does this work? When a company makes a profit, it can choose to distribute a portion of that profit to its shareholders. The portion of the profits that shareholders receive is called a dividend, and the more shares you own, the more dividends you get. For example, if a company pays a dividend of $2 per share and you own 50 shares, you’ll get $100 in dividends. 

However, not all companies pay dividends, and the decision to pay dividends (and how much!) depends on the company’s profitability, financial health, and growth strategy. Some companies prefer to reinvest their profits into the company to grow — and hopefully grow the value of each share in the process.

Now, not just any dividend catches an investor’s eye — it's the growth of these dividends over time that really matters. Understanding the concept of dividend growth could put you ahead in the game of making smart investment choices. 

Let's get started with what exactly a dividend growth rate is, how to keep an eye on your annual dividend growth rate, and why it's a big deal for your wallet.

What is a dividend growth rate (DGR) and why is it important?

The dividend growth rate is a tool that shows how fast a company's dividends are growing. Dividends are a type of unearned income that you get without having to actively work for it, unlike wages from a job.

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A DGR is the rate at which a company’s dividends per share grow from one year to the next. Companies that consistently raise their dividends are often in great financial shape and tend to be some of the most popular in the stock market.

This growth is huge for your wallet because it suggests your income stream from investments could increase yearly without any work from you. That’s one of the biggest benefits of passive income vs. active income. Pretty awesome, right?

Understanding high DGRs

When you come across high-dividend growth stocks, you're looking at companies that are on a financial winning streak. They’re increasing their dividends over a short period of time, which is great news for investors. 

This means that if you hold these stocks, you're likely to see more cash coming your way regularly. It’s like having a business that keeps giving you bigger bonuses!

Analyzing low DGRs

Now, low DGRs aren't necessarily the villains of the investment world, but they do need a closer look. A low DGR typically means that a company is hanging on to its cash. While this might sound a bit gloomy, it isn't always bad news. Some companies might be setting up for a major growth spurt by investing in their future now. 

If a company's dividends aren’t growing much, it's a good idea to dig deeper with other key indicators to figure out what’s up. Is it just in a rough patch, or is there a bigger issue at play? Understanding both high and low DGRs helps you keep your dividend investment strategy on track and your investments working hard for you.

How to calculate the rate of dividend growth (with examples)

Knowing how to calculate the dividend growth rate is a lot simpler than you might think. You use the dividend growth rate formula to see how much a company's dividends have increased over a year:

• DGR = (Dividend at the end of year - Dividend at the start of the year) / (Dividend at the start of the year) X 100

This formula calculates the growth rate as a percentage. Imagine a company paid a dividend of $1.00 per share last year and this year, it paid $1.10 per share. Here’s how you'd plug those numbers into the formula:

• DGR = (1.10 - 1.00) / (1.00) X 100 = 10%

So, the dividends grew by 10% over the past year. This quick calculation shows you the growth trend of your investment’s dividends, letting you see how your future dividends might increase over time. To get an even deeper understanding of a stock’s performance, you can calculate the DGR for several years and look at the average dividend growth rate. 

Dividend yield vs. dividend growth: How are they different?

Let's break down the difference between dividend yield and dividend growth — two key terms that every dividend growth investor should know. Dividend yield is all about the here and now. It's calculated from the current stock price and shows you the percentage of that price you get back in dividends each year, telling you what you're earning from your shares at the moment.

On the flip side, dividend growth focuses on your future gains. It tracks how much the dividend per share is expected to increase over time. It's a peek into the potential growth of your future dividend payments, helping you see how your returns might expand as you hold on to those long-term dividend stocks. So, while dividend yield gives you the immediate rate of return on your initial investment, dividend growth points to how much more profitable your stocks could become.

Dividend discount model: Predicting dividend payments

The dividend discount model (DDM) is like your crystal ball for predicting dividend payments. This handy mathematical formula helps you estimate the value of a dividend growth stock based on the dividend payout expected in the future. It operates on the idea that a stock's price today should equal the sum of all its future dividend payments, discounted back to their present value. 

• Price = (Dividend per share X (1 + Growth rate)) / (Discount rate - Growth rate)

In this formula:

• Dividend per share: Amount paid out in dividends each year per share

• Growth rate: Expected annual rate of increase in dividends

• Discount rate: Required rate of return or the interest rate used to discount future dividend payments

For example, let’s take a stock currently paying a dividend of $2.00 per share, and you expect the dividends to grow at a rate of 5% per year. If your required rate of return (the discount rate) is 10%, you can calculate the fair value of the stock using the DDM formula:

• Price = ($2.00 X (1 + 0.05)) / (0.10 - 0.05) = ($2.00 X 1.05) / (0.05) = $42

Using the DDM, also known as the dividend growth model formula, investors can figure out whether a stock is undervalued or overvalued based on its projected cash flows. In this example, the DDM suggests that the fair value of the stock is $42 per share. If the current market price is below $42, it might be considered undervalued based on its future dividend growth prospects.

Unlock the skills to invest with Greenlight

Navigating dividends and investing can be an exciting adventure, and you’re in great company on this journey. Try the Greenlight investing app for kids¹ and teens to learn about investments, including dividend growth stocks and dividend investment strategies.

¹Greenlight is a financial technology company, not a bank. The Greenlight app facilitates banking services through Community Federal Savings Bank (CFSB), Member FDIC.