In hopes of getting better numbers to project off of, I've been compiling data to calculate the dividend growth rate of my entire portfolio. Easy right? Just add up the dividend growth rate for each position and divide by the total number of positions. Well, that's not quite right because each position is a different size and therefore contributes a different amount to the overall dividend growth. A 10% position of your portfolio growing the dividend at 20% per year changes your dividends received a lot more than a 1% position growing the dividend at 20% per year. So how do you calculate it then?
In order to calculate the overall dividend growth rate you have to take a weighted average. Per Investopedia, a weighted average is "an average in which each quantity to be averaged is assigned a weight. These weightings determine the relative importance of each quantity on the average. Weightings are the equivalent of having that many like items with the same value involved in the average." Essentially you're assigning a weight to each position, in this case that would be the weighting of your portfolio. You then multiply the weight by the dividend growth rate of your choice, 1 year, 3 year, 5 year, 10 year, since the start of the dividend being increased. Whatever you choose.
The formula works out as (DG1 * MV1 + DG2 * MV2 + DG3 * MV3 + DGn * MVn) / (M1 + M2 + M3 + Mn), where DGn = the dividend growth rate of position n and MVn = market value of position n. If you go through the math, this is equivalent to DG1 * W1 + DG2 * W2 + DG3 * W3 + DGn * Wn, where Wn = the weighting of position n in the whole portfolio or MVn / Total Portfolio Value.
Luckily with spreadsheets it's very easy to calculate this. In Excel or Google Spreadsheet you use the =sumproduct(range of cells for weight, range of cells for growth rate) or if you want to do it the other way you can use =sumproduct(range of cells for market value, range of cells for growth rate) / sum(range of cells for market value). I find it easiest to just use the weighting that I've already got calculated in my portfolio spreadsheet. In my spreadsheet, my formula looks like this = sumproduct(B3:B25,C3:C25) that's the formula in C27 next to Weighted Average Growth Rate.
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You can take it a step further by weighting the dividend growth rates if you so choose. For example, say you have the 1 year, 3 year, 5 year and 10 year dividend growth rates for each company that you own. You could weight them to give the longer dividend growth rates more value than the shorter growth rates. To calculate that I would use take each of the dividend growth rates and multiply them by their corresponding weights. For the weights, I would use 1 + 3 + 5 + 10 = 19 as my total and the 1 year growth rate by 1/19, the 3 year growth rate by 3/19, the 5 year growth rate by 5/19 and the 10 year growth rate by 10/19. The weighted average dividend growth rate for that company is simply the sum of all of those. For example, say a company has a 1 year growth rate of 5%, 3 year growth rate of 8%, 5 year growth rate of 10% and 10 year growth rate of 12%. The weighted average would be 0.05 * 1/19 + 0.08 * 3/19 + 0.10 * 5/19 + 0.12 * 10/19 = 10.47%.
Personally I'd make a change to the weights and reverse the weights. So the 1 year growth rate weight becomes 10/19, 3 year growth rate becomes 5/19, 5 year growth rate becomes 3/19 and the 10 year growth rate becomes 1/19. The reason I prefer to do it this way is because over a 10 year period a company will have experienced quite a bit of growth in revenue, earnings and dividends per share. If the dividend growth rate has exceeded the earnings per share growth rate then the payout ratio has increased. This could lead to slower dividend growth going forward, so I would want to place more weight on the more recent dividend growth rates. Using the same values for the growth rates as above, but reversing the weights gives a weighted average dividend growth rate of 6.95%.
You would then go through this same process of weighting the dividend growth rates for each position and repeat the previous steps to calculate the overall weighted dividend growth rate for your portfolio. Calculating a weighted average dividend growth rate for you entire portfolio is good to know because it lets you see just how much organic growth in your dividends you can expect to receive. This allows for better projections of future dividends which makes it a lot easier to project when your dividend income might be able to surpass your expenses, meaning you're reached financial independence.
The equation becomes much simpler if you are taking the dividends as cash, i.e. not reinvesting the dividends at all, and are not adding any fresh capital to the portfolio. In that case the easiest way to calculate the overall dividend growth rate is to divide the current year's dividends by the previous year's dividends and subtracting 1 to get the growth rate. For example, 2012 Dividends / 2011 Dividends - 1 = Year over Year Dividend Growth Rate.
In the above spreadsheet I'm calculating a weighted 1 year, 3 year, 5 year and 10 year growth rate as well as a overall weighted dividend growth rate using the reversed weights from above. Some calculations are different since not all positions (KMI, PM, PSX) have even been around for 10 years. I'm happy to see a 11%+ overall dividend growth rate for my FI portfolio and 20%+ for my Roth IRA, although I fully expect the Roth growth rate to come down from its current lofty levels.
Be careful in projecting elevated growth rates very far into the future because it will overestimate the actual growth and you will be quite disappointed by the results. I used a 5% dividend growth rate for my projections for reaching FI, but using the weighted average growth rate from my calculations would mean I would hit FI a full 5 years earlier while keeping everything else the same. I'd much rather be conservative in my assumptions and be pleasantly surprised than too aggressive and be disappointed.
*Thanks to All About Interest for showing me the error of my ways. Instead of calculating based off the portfolio weight, it should be calculated on the dividend weight. Dividend weight is the forward dividends for each position divided by the total forward dividends of the portfolio. The weighting process remains the same.