What it means
A dividend is a share of profit paid out in cash, and its growth rate is simply the annual rate at which that payment has risen. A company that paid $1.00 a share five years ago and pays $1.61 today has grown its dividend by about 10% a year.
Compounding does the rest of the work. The rate matters because it drives both income and valuation.
Two shares yielding 3% today are not equivalent if one grows its dividend at 8% a year and the other has not raised it in a decade, and over a long holding period that difference dominates the original yield. There are two ways of arriving at the number.
The historic method takes the first and last dividends of a period and calculates the compound annual growth rate between them, while the sustainable method estimates what the company can support from its own earnings. Analysts usually calculate both and worry when they diverge sharply.
The sustainable version is the more revealing of the two. It multiplies return on equity by the proportion of earnings retained rather than paid out, on the logic that reinvested profit is what funds future growth.
A business paying out almost everything it earns has little left to grow with. Dividend growth is never guaranteed and is not owed to anyone.
Boards can cut, freeze or suspend payments whenever trading deteriorates, so a long unbroken record of increases indicates management's intent and the strength of the business rather than any binding promise.
In practice
Real-world examples.
Example
A consumer goods group has raised its dividend every year for two decades at an average of 6% a year. A retired investor holds it precisely because the income has grown faster than inflation over that period, even though the starting yield was modest.
Example
An analyst covering a utility notices that its dividend has grown 8% a year while earnings grew only 2%. The payout ratio has climbed from 45% to 85%, and she downgrades the share because the growth has been funded by paying out an ever larger slice of a barely growing profit.
Example
A private company's shareholders agree a policy of raising the annual distribution by 5% a year provided net profit covers it at least twice. The rule gives the family predictable income while protecting the cash the business needs for equipment.
Think of it
“Dividend growth rate is how fast a company increases its dividend-the yearly percentage bump.
Formula
Calculation
Historic growth rate = (latest dividend / earliest dividend) raised to the power of 1 / n, minus 1, where n is the number of years between them. Sustainable growth rate = return on equity x retention ratio.
A company paid a dividend of $1.00 a share five years ago and has just declared $1.61. The ratio is $1.61 / $1.00 = 1.61, and since 1.10 multiplied by itself five times equals 1.61051, the compound annual growth rate is very close to 10%.
Now check whether that is sustainable. The company earns a return on equity of 15% and pays out 40% of its profits, so it retains 60%. Its sustainable growth rate is 15% x 0.60 = 9%, comfortably close to the 10% achieved, which suggests the record is supported by the underlying business rather than by stretching the balance sheet.Case study
Seen in the real world.
Wexley Pumps is a fictional industrial supplier created here to illustrate how the calculation is used. In this hypothetical case it had increased its dividend from $0.50 to $0.90 a share over eight years, a compound rate of roughly 7.6% a year, and its board treated the record as a point of pride.
A new finance director ran the sustainable growth test and found return on equity had drifted down to 9% while the payout ratio had risen to 70%, implying sustainable growth of only 9% x 0.30 = 2.7%. The gap meant recent increases had been funded partly by borrowing rather than by trading profit.
The illustrative board chose to hold the dividend flat for two years while margins were repaired, then resume increases at a rate the business could actually support. Shareholders disliked the pause but avoided the far more damaging cut that would otherwise have followed.
Watch out
Common mistakes.
- Averaging the yearly percentage increases instead of compounding them. A simple average overstates growth whenever the annual changes are uneven, so a compound calculation should always be used.
- Reading a high growth rate as good news without checking the payout ratio. Growth funded by paying out an ever larger share of static earnings runs out quickly.
- Measuring from an unusual starting year. If the first dividend in the period was cut or was a one-off special payment, the calculated growth rate is meaningless.
Questions
People also ask.
What is a healthy dividend growth rate?
For an established business, growth a little above inflation, typically in the range of 4% to 8% a year, is usually considered sustainable.
Why do some profitable companies pay no dividend at all?
Because they can reinvest profits at a higher return than shareholders could achieve elsewhere, so growth in the share price replaces the income.
Does a special one-off dividend count in the calculation?
It should be excluded, since including it distorts both the starting and ending points and implies a level of ordinary payment the company never intended.
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