Does Merck's Dividend Have Room to Soar?

With interest rates still sitting near record lows, investors looking for current income have been forced to move from fixed-income positions and into stocks to find yield. To help offset those risks, one of the first things dividend investors do is look for companies operating in stable, growing industries like Merck . But before doing the foolish thing and taking this dividend for granted, let's take a closer look at whether it's truly worthy of a spot in your portfolio.

Health is priceless; health care isn't.
As a pharmaceutical company, Merck benefits from many of the unique elements of the industry that make it attractive for dividend investors. We all know it's impossible to put a price on one's health and well-being. Because of that, and due to the unbearable cost of emergency health problems, insurance companies and government entitlement programs have taken over as the gatekeepers of health care spending around the world.

But the industry's high costs didn't just appear out of thin air. Partly to blame is the fact that our insurance systems have effectively masked the direct costs of health care by turning the system into a kind of all-you-can-eat buffet, removing most of the consumer-driven pricing mechanisms that exist in practically every other industry. This dynamic, along with the aging and increasingly unhealthy society that we're all well aware of, is a key reason health care spending will continue to grow.

But while these big picture trends might be driving the overall industry, investors looking at specific health care dividend stocks need to dig a layer deeper to understand the company-specific issues at work. After all, dividends aren't a guarantee, and if the going gets tough enough, even a "stable" health care stock could cut -- or eliminate -- its dividend. With that being said, let's check on where Merck's dividend has been, and try to determine where it's going.

Payout ratios
A quick-and-dirty technique for checking a dividend's sustainability is taking a look at something called the payout ratio. Typically this is expressed as a percentage, looking at a company's dividend per share relative to its net income per share. That's a decent start, but I prefer to use a slightly different measurement that replaces net income, an accounting measurement, with something more tangible -- cold hard cash. The chart below shows how much of Merck 's free cash flow has been eaten up by its dividend payments over the past two years. The lower the better, suggesting more capacity for future dividend hikes.

Valuation
Not all dividends are created equal. At first glance a high dividend yield may look nice, but all too often it means a problem is lurking around the corner for a business. Looking at Merck's 3.8% dividend yield in isolation only tells half of the story, which is why investors need to have an understanding of how the market perceives a company prior to buying a stock. We can do this by comparing a few financial multiples, like price to earnings, to its peers in the industry.

Future growth
Up to this point, we've looked at Merck's dividend in the past, and we've also seen how its stock is being perceived by the market today. However, the most important factor to consider when understanding a dividend's future is where the company's cash flow is heading. It's hard to generate more cash without growing sales, so let's take a look at what industry analysts are expecting for Merck's revenue growth relative to peers this year.

Foolish bottom line
From patent expirations to pipeline delays Merck is dealing with a variety of headwinds. However, the most significant is last August's U.S. patent expiration of Singulair, an asthma drug that generated about $5.5 billion in sales in 2011. With about 10% of sales exposed to generic competition, revenue growth will be hard to come by for the next year or two. Cost cutting will help drive some earnings growth, but until the top line begins growing, don't expect any meaningful boost in Merck's dividend.

Can Merck beat the patent cliff?
This titan of the pharmaceutical industry stumbled into 2013 and continues to battle patent expirations and pipeline problems. In a new premium research report on Merck, The Fool tackles all of the company's moving parts, its major market opportunities, and reasons to both buy and sell. To find out more click here to claim your copy today.

The article Does Merck's Dividend Have Room to Soar? originally appeared on Fool.com.

Brenton Flynn has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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