In this article, I will show you how to estimate the perpetual dividend growth rate in dividend discount models. A key and sensitive input in these models, the perpetual dividend growth rate is the expected rate at which a company's dividends will grow indefinitely. It's essential to accurately estimate this rate as it significantly influences the valuation of a company's stock when projected into perpetuity. There are numerous methodologies that investors can employ to estimate this continual dividend growth, and this article will focus on discussing these approaches in detail.

We'll use 3M Company (MMM) as our example in this article, a multinational conglomerate known for its innovative products across various sectors like healthcare, safety, and consumer goods. Its status as a large, blue-chip company with a consistent and long-term history of paying and growing dividends makes 3M an ideal subject for dividend discount models. The company's stable financials and predictable dividend increases offer a strong foundation for estimating the perpetual dividend growth rate, providing a practical example for applying these valuation techniques.

Method #1: Historical Dividend Growth Rates

The first method for estimating a firm's perpetual dividend growth rate is to simply base it on historical growth rates. A detailed analysis of historical dividend growth over an extended period, such as 5+ years, is beneficial for a thorough understanding. However, it's also crucial to pay attention to the firm's recent dividend growth trends, as they can provide valuable insights into the current and near-future financial health of the company.

For illustration purposes, I've collected dividend data for 3M Company from 2000 to 2023, as shown below:

As you can see, although the dividend growth hasn't been perfectly linear, 3M Company has still shown a stable and increasing dividend trend.

We can utilize the compound annual growth rate (CAGR) calculation, as opposed to a simple average, to get a better picture of the company's historical dividend growth. This enhances the accuracy of the estimation, as CAGR effectively captures the compounding nature of dividend growth, offering a realistic picture of how dividends have grown year over year.

The formula for CAGR is shown below:

CAGR = [(Ending Value / Beginning Value)^{(1 / Number of Years)}] - 1

If we calculate the CAGR over the last 10 years, in increments of 2 years, we can assess how the CAGR has trended over time, as shown in the table below:

As you can see, the company's dividends, although growing, have slowed down in terms of growth. We can also cross-reference historical average growth rates. If we take the average dividend growth rate over the 5-year, 3-year, and 1-year periods, we get 2.0%, 0.7%, and 0.7% respectively, also clearly showing a decline in the firm's dividend growth rate.

Based on the company's historical dividend growth rate and assuming that 3M Company continues to maintain this dividend growth pattern, a perpetual dividend growth rate estimate between 0.5% and 1.0% would be reasonable.

Method #2: Sustainable Dividend Growth Rate

The sustainable dividend growth rate offers a useful approach to estimating the amount by which a company can increase its dividend sustainably, without needing additional external funding. This method is particularly advantageous for dividend discount models (DDMs), as it takes into account the company's profitability and the proportion of its earnings paid out as dividends. This approach often provides a more realistic growth estimate compared to solely historical data or analyst forecasts, as it is grounded in the company's actual financial performance.

The sustainable dividend growth rate formula is shown below:

Sustainable Dividend Growth Rate = ROE * (1 - (DPS / EPS))

where:

• ROE = return on equity (net income / average shareholders' equity)
• DPS = annual dividend per share
• EPS = earnings per share ((net income - preferred dividends) / weighted average outstanding shares)

In this formula, return on equity (ROE) gauges a company's profitability relative to shareholder equity, reflecting how effectively it uses shareholder capital to generate profits. A higher ROE denotes greater efficiency in profit conversion. The dividend payout ratio (DPS/EPS) indicates the proportion of earnings distributed as dividends; a lower ratio implies more earnings are retained for potential reinvestment and growth.

The sustainable dividend growth rate formula integrates these metrics to project a company's potential dividend growth without increasing the payout ratio or seeking additional capital. It assumes that retained earnings will be reinvested at a ROE level, facilitating growth. Consequently, the formula reflects the principle that dividend growth sustainability is driven by the contribution of retained earnings to profitability and the extent of their reinvestment.

Using numbers from 3M Company's FY 2022 financial statements, we can calculate the firm's sustainable dividend growth as follows:

Sustainable Dividend Growth Rate (MMM) = 0.39 * (1 - ($6.00 / $10.21)) --> 16.08%

The sustainable dividend growth rate of 16.08% for 3M Company, substantially higher than typical for mature companies, is supported by a strong return on equity (ROE) of 39% and a low dividend payout ratio (DPR) of 58.8% ($6.00 / $10.21). However, expecting such a high rate to persist indefinitely may not be realistic for a mature company like 3M. Thus, while 16.08% serves as an upper limit based on current financials, a more conservative, realistic rate is likely more appropriate for long-term valuation.

Method #3: Augmented Sustainable Dividend Growth Rate

This alternative approach enhances the traditional sustainable dividend growth rate method by incorporating stock buybacks, a common method for companies to return cash to shareholders indirectly. Including this factor, the calculation can yield a more precise estimate of the sustainable dividend growth rate, taking into account the cash redistributed to shareholders via buybacks.

The simplest way to incorporate stock buybacks into a dividend discount model (DDM) is by adding them to dividends and dividing the total by net income, resulting in an augmented payout ratio. To adjust for the possible increase in financial leverage that stock buybacks may introduce, subtracting any new long-term debt issued from this total can also improve the accuracy of the calculation. This method recognizes buybacks as a way to distribute value to shareholders and considers their potential impact on the company's financial leverage.

The complete augmented dividend payout ratio is shown below:

Augmented Dividend Payout Ratio = (Dividends + Stock Buybacks - New Long-Term Debt Issued) / Net Income

The augmented dividend payout ratio provides insight into how much of a company’s profit is being used for shareholder returns, considering both equity reduction (via buybacks) and new debt. A higher ratio indicates a greater proportion of net income being returned to shareholders, which could either be a sign of a company's strong profitability or an aggressive return policy, potentially at the expense of future growth or financial flexibility.

In the context of DDMs, this ratio helps in fine-tuning the sustainable growth rate by accounting for the total return yield to shareholders. This can offer a more comprehensive picture, particularly for companies that actively engage in buybacks as part of their shareholder return strategy. However, it's important to assess the context of these financial decisions to determine if they truly reflect underlying financial strength or if they're artificially supporting the share price, which could be unsustainable in the long term.

Now, to calculate 3M Company's augmented dividend payout ratio, obtain data on dividends, stock buybacks, and new long-term debt from the financing activities section of its cash flow statement, and net income from its income statement. These figures can be found in the company's 10-K annual report. It's important to use figures from the same reporting period for accuracy.

3M Company's financing activities section for FY 2022 is shown below:

In FY 2022, 3M Company's financial activities included issuing new long-term debt of $1M, distributing dividends totaling $3,369M to common stock shareholders, and repurchasing $1,464M in stock. With a reported net income of $5,777M for the same year, we have the necessary data to compute 3M Company's augmented dividend payout ratio.

Here's what this step would look like for 3M Company:

Augmented Dividend Payout Ratio (MMM) = ($3,369M + $1,464M - $1M )/ $5,777M --> 83.6%

After calculating the augmented dividend payout ratio, we can then solve for the augmented sustainable dividend growth formula, as shown below:

Augmented Sustainable Dividend Growth Rate = ROE * (1 - Augmented Dividend Payout Ratio)

where:

• ROE = return on equity (net income / average shareholders' equity)

The augmented sustainable dividend growth rate for 3M Company would be calculated as follows:

Augmented Sustainable Dividend Growth Rate (MMM) = 0.39 * (1 - 0.836) --> 6.4%

The augmented sustainable dividend growth rate of 6.4%, calculated by including dividends, stock buybacks, and new long-term debt, provides a more nuanced and conservative estimate of a company's dividend growth potential compared to the 16.08% rate from the standard sustainable growth formula. This lower rate, reflecting a wider range of financial activities, is likely more realistic for mature companies. For investors, it offers a more grounded view of the company's long-term dividend growth potential, taking into account its profitability and capital management practices.

Repeating this calculation over a 3-5 year period and averaging the results is recommended. This approach can help balance any skewed outcomes caused by years with no stock buybacks or those with unusually high or low levels of stock buyback activity. The following table illustrates this for 3M Company:

As you can see, the augmented sustainable dividend growth rate can vary significantly from year to year. Therefore, using the most conservative figure (in our case, 2.0%) or an average might yield the most accurate estimate of the firm's perpetual dividend growth rate.

Lastly, it's important to note that if the firm being evaluated did not repurchase any shares, subtracting new long-term debt from the augmented dividend payout ratio calculation would be unnecessary. In such cases, the formula reduces to dividends divided by net income, essentially the dividend payout ratio. Thus, calculating the augmented sustainable dividend growth rate would yield a result very similar or identical to the sustainable dividend growth rate. Averaging the results might still be useful (as shown in our table above), but without significant share repurchases in recent years, there's little reason to prefer the augmented method over the standard sustainable dividend growth rate method.

Method #4: Future Dividend Growth Rate Analyst Estimates

The fourth method for estimating future dividend growth is to rely on analysts' forecasts. While this method offers a quick approach, it is important to note that the underlying rationale for these forecasts may not always be clear. Furthermore, the reliability of such estimates typically decreases the further out the projection extends and with fewer analysts contributing to the consensus. This method is convenient, but it is important to be aware of its potential limitations in precision.

You can use SeekingAlpha (or other stock research platforms), after searching for a dividend-paying company, to see what analysts predict for the next year's dividend. This is shown below for 3M Company:

As you can see, 8 analysts estimate an annual dividend of $6.12 for 3M Company in 2024 (1.2% YoY growth from 2023 to 2024), and 6 analysts predict a dividend of $6.34 in 2025 (3.6% YoY growth from 2024 to 2025). Considering 3M Company's historical dividend growth, the more conservative and realistic assumption is that the firm's dividends will continue to grow at 1.2%.

Selecting the Appropriate Perpetual Dividend Growth Rate

When deciding on the appropriate perpetual dividend growth rate for dividend discount valuation models, the first item to check is whether the selected dividend growth rate (g) is lower than the discount rate (r). Otherwise, this could lead to illogical valuations, such as negative or undefined company values.

Additionally, it's important to set the perpetual dividend growth rate reasonably below or equal to the growth rate of the economy where the firm operates. No firm can sustain growth rates exceeding the economy's growth rate (or, as a proxy, the risk-free rate) indefinitely.

Several options are available to ensure this criterion is met:

1. Economy's Growth Rate Cap: This approach involves capping the perpetual dividend growth rate at the same level as the economy's growth rate. If your model allows, consider a slight exceedance, permitting the growth rate to surpass the economy's Gross Domestic Product (GDP) growth by a margin of 1-2%. This method aligns the company's potential growth with the broader economic environment. It's based on the understanding that a company's long-term growth can't consistently outpace the economy it operates in, as the company's opportunities are ultimately linked to economic conditions.
2. Risk-Free Rate Benchmarking: Using the risk-free rate as a benchmark is another viable approach. Typically, the interest rate on the 10-year U.S. Treasury Note is used as a standard. This rate, being secure and free of default risk, serves as a conservative yet realistic limit for dividend growth projections. The rationale behind this method is that the risk-free rate often reflects the minimum return investors expect, and using it as a benchmark ensures that the growth rate does not exceed what the broader market considers a risk-free return.
3. Inflation and Economic Growth Combination: This strategy involves combining the long-term inflation rate with the average economic growth rate. For multinational companies like 3M Company, you would use the long-term growth rate of the global economy. This method gives a more comprehensive view by incorporating both inflationary trends and economic growth expectations into the growth rate estimation. It acknowledges that a company's growth is influenced by both the economic environment (reflected in GDP growth) and the value of money (reflected in inflation rates).

Based on our observations from the four methods discussed in this article, a 1.0% perpetual dividend growth rate seems the most realistic for 3M Company. Although this is slightly above 3M Company's historical dividend growth rate over the last couple of years, our sustainable and augmented sustainable dividend growth rate calculations indicate that there's plenty of room for the firm's dividends to grow. Lastly, this rate is currently below the economy's growth rate, the risk-free rate, and the combined rate of inflation and economic growth, which indicates that the firm's perpetual dividend growth isn't excessively high.

The Bottom Line

In dividend discount models, accurately estimating the perpetual dividend growth rate is crucial, as it significantly influences a company's stock valuation when projected into perpetuity. This article explored four methods to estimate this critical rate effectively, as summarized below:

1. Historical Dividend Growth Rates: This method involves analyzing a company's past dividend growth over an extended period. It offers a fundamental understanding but must be tempered by current financial realities and trends.
2. Sustainable Dividend Growth Rate: This approach calculates dividend growth potential based on a company's return on equity and dividend payout ratio. It provides a growth rate grounded in the company's actual financial performance, often yielding a realistic estimate.
3. Augmented Sustainable Dividend Growth Rate: This enhanced method accounts for stock buybacks and new debt, offering a more nuanced estimate by considering a broader range of financial activities.
4. Future Dividend Growth Rate Analyst Estimates: Analyst forecasts can also be used as a quick method to estimate future growth, although this approach may be less precise due to the variability and uncertainty of such predictions.

When selecting the appropriate perpetual dividend growth rate, it's crucial to confirm that it is lower than the discount rate (aka required rate of return) to prevent unrealistic valuations. Moreover, setting the growth rate in line with the economy's overall growth or benchmarking it against the risk-free rate helps establish a realistic ceiling for projecting dividend growth.

The chosen growth rate should reflect a balance between historical performance, financial stability, and broader economic factors. It should be conservative enough to be realistic over the long term while aligning with the firm's overall growth potential and the economic environment in which it operates. This balanced approach ensures a more accurate and reliable valuation in dividend discount models.