Before buying an interest in a publicly traded company, there are a number of things that you should think about. These things include the company's business model, valuation and future earnings growth. Another important consideration is the dividend. It's important to remember that from 1930 to 2012, dividends accounted for about 42% of the gains in the S&P 500.
Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. A lot of these investors will buy dividend-paying stocks that are in many different sectors of the economy in order to diversify their risk profiles.
Today, let's take a look at two of the biggest dividend payers in the pharmaceutical industry, Pfizer (PFE) and Merck (MRK), and assess the strength and sustainability of their dividends. We'll also find out which of these industry behemoths has the most potential for dividend growth going forward.
The most obvious consideration when comparing dividends from different companies is the dividend yield, which represents the percentage of your investment that you will receive back over the next 12 months, provided that the dividend doesn't change over that time.
Right now, both Pfizer and Merck yield 3.2%. These yields are both forward yields that reflect dividend increases that took place over the last 12 months. These yields are respectable, and they're evenly matched. So, there's no clear winner in this category.
When analyzing a dividend, there's more to it than just the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation as well as to show confidence from management in the company's outlook. Table 1 shows the average dividend growth rate from our two companies over the last five years.
Table 1 shows an impressive double-digit dividend growth rate for Pfizer. Back in February, Pfizer increased its dividend by a respectable 8.3%. Merck's dividend remained static from 2004 to 2011. In 2012, Merck increased its dividend by 10.5%, but then only increased it by 2.3% in 2013 and then by the same amount in 2014.
Pfizer increased its dividend 5 years in a row after cutting it by 50% in 2009. Merck has increased its dividend 3 years in a row after freezing it for 8 consecutive years.
Free Cash Flow Payout Ratio
While it's nice to see high yields and strong dividend growth rates, we need to make sure that the companies in question are generating enough free cash flow to keep the dividend payments going. For this reason, I like to calculate the free cash flow payout ratio, which is the percentage of free cash flow that is eaten up by dividends over a given period of time. Lower free cash flow payout ratios are better as they leave more room for other activities as well as for future dividend increases.
Free cash flow is basically the cash flow a company generates in its operations minus capital expenditures required to maintain or expand the business.
Table 2 shows that the dividends from these two companies do not appear to be in any sort of danger at this time. These two companies are currently generating more than enough free cash flow to cover their dividend payouts. Pfizer looks especially good here, with its dividend consuming less than half of its free cash flow.
Earnings Per Share Growth Forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth.
The earnings forecasts of these two companies do not look all that inspiring. Pfizer is expected to produce between 1% and 3% earnings-per-share growth over the next couple of years, while Merck is expected to see a small drop in earnings per share this year, followed by decent growth next year.
Right now, both Pfizer and Merck have respectable dividend yields along with healthy free cash flow payout ratios that leave plenty of room for future dividend growth. If earnings-per-share growth forecasts hold true for the next couple of years, expansion in the payout ratios for both companies will need to happen in order for current levels of dividend growth to continue. Right now, it appears that both companies have plenty of room for that.
When it comes to who stands to see the most dividend growth over the next few years, I would give the edge to Pfizer, which unlike Merck has shown a willingness over the last few years to increase its dividend by respectable amounts, while Merck's latest increases have barely been keeping up with inflation. Of course, Merck could change that in the near future with more substantial increases as it certainly has the financial flexibility with which to do so.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.