The 3 Keys to Merck's Returns

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Despite constant attempts by analysts and the media to complicate the basics of investing, there are really only three ways a stock can create value for its shareholders:

  1. Dividends.
  2. Earnings growth.
  3. Changes in valuation multiples.

In this series, we drill down on one company's returns to see how each of those three has played a role over the past decade. Step on up, Merck (NYS: MRK) .

Merck shares delivered a net loss of 15.6% over the past decade. How'd they get there?

Dividends softened much of the blow. Without dividends, shares returned negative 46% over the past ten years.

Earnings growth was utterly absent over the period. Indeed, Merck's normalized earnings per share actually declined by an average of 1.4% a year for the past decade. Consider that inflation has eaten up roughly one-quarter of a dollar's purchasing power over that period, and this is simply awful. As some condolence, earnings growth at rival Pfizer (NYS: PFE) and Eli Lilly (NYS: LLY) hasn't been much to speak of, either. It's been a rough decade for big pharma.

Now have a look at Merck's valuation multiple:

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Source: S&P Capital IQ.

Merck's valuation multiple has indeed declined over the past decade, but not by much -- an oddity among large-cap companies, most of which have seen valuations plunge since the end of the dot-com boom. On a forward-looking basis, Merck shares trade at about nine times estimated earnings, which does look cheap. After a decade of poor returns, investors don't expect much out of Merck. For those with a long-term perspective, that's a good thing. Shares are priced for virtually no growth. Anything above that could reward shareholders handsomely.

Why is this stuff worth paying attention to? It's important to know not only how much a stock has returned, but where those returns came from. Sometimes earnings grow, but the market isn't willing to pay as much for those earnings. Sometimes earnings fall, but the market bids shares higher anyway. Sometimes both earnings and earnings multiples stay flat, but a company generates returns through dividends. Sometimes everything works together, and returns surge. Sometimes nothing works and they crash. All tell a different story about the state of a company. Not knowing why something happened can be just as dangerous as not knowing that something happened at all.

At the time this article was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Motley Fool newsletter services have recommended buying shares of Pfizer. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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