Merck & Co. Inc.: I'm Long, But It Screams Overvalued Today

Jul.23.14 | About: Merck & (MRK)

Summary

MRK is the single most expensive company in the DJIA by price to earnings, nearly double the DJIA’s median of 18.4.

Merck’s current earnings payout ratio is nearly 116%.

I am long Merck but do not recommend purchasing shares of MRK at today’s prices.

I discussed the most undervalued companies currently in the Dow Jones Industrial Average ("DJIA") in Chevron: The Most Undervalued DJIA Component, which featured a slight focus at the end of the article on Chevron, the most undervalued company of the DJIA right now. This article is a continuation of my previous DJIA research and identifies the three DJIA companies which appeared most often among bottom 20% of DJIA companies when looking individually at:

  • percent above 52-week low;
  • dividend yield;
  • earnings payout ratio;
  • price to earnings;
  • price to sales; and
  • price to book.

METHODOLOGY

Wikipedia was used to obtain the list of companies classified as a DJIA component. All metric and trading data was obtained from Yahoo! Finance. For each metric listed above the companies were sorted by their respective metric value from least to greatest, except for dividend yield which was sorted from greatest to least. Each company was assigned an initial point value of zero. A point was then assigned to each of the top six companies for each metric and a point was subtracted from each company in the bottom six for each metric. This means a maximum of 6 points and a minimum of -6 points was possible. The distribution of cumulative points for all six metrics can be seen below in Chart 1 (which, yes, happens to be a perfectly-shaped bell curve) and a complete list of the DJIA companies analyzed is available in Table 1.

Chart 1. Cumulative Point Distribution

Table 1. The DJIA Companies Analyzed

Symbol

Company

(NYSE:AXP)

American Express Company

(NYSE:BA)

The Boeing Company

(NYSE:CAT)

Caterpillar Inc.

(NASDAQ:CSCO)

Cisco Systems, Inc.

(NYSE:CVX)

Chevron Corporation

(NYSE:DD)

E. I. du Pont de Nemours and Company

(NYSE:DIS)

The Walt Disney Company

(NYSE:GE)

General Electric Company

(NYSE:GS)

The Goldman Sachs Group, Inc.

(NYSE:HD)

The Home Depot, Inc.

(NYSE:IBM)

International Business Machines Corporation

(NASDAQ:INTC)

Intel Corporation

(NYSE:JNJ)

Johnson & Johnson

(NYSE:JPM)

JPMorgan Chase & Co.

(NYSE:KO)

The Coca-Cola Company

(NYSE:MCD)

McDonald's Corp.

(NYSE:MMM)

3M Company

(NYSE:MRK)

Merck & Co. Inc.

(NASDAQ:MSFT)

Microsoft Corporation

(NYSE:NKE)

Nike, Inc.

(NYSE:PFE)

Pfizer Inc.

(NYSE:PG)

The Procter & Gamble Company

(NYSE:T)

AT&T, Inc.

(NYSE:TRV)

The Travelers Companies, Inc.

(NYSE:UNH)

UnitedHealth Group Incorporated

(NYSE:UTX)

United Technologies Corp.

(NYSE:V)

Visa Inc.

(NYSE:VZ)

Verizon Communications Inc.

(NYSE:WMT)

Wal-Mart Stores Inc.

(NYSE:XOM)

Exxon Mobil Corporation

Click to enlarge

METRIC 1. PERCENT ABOVE 52-WEEK LOW

Percent above 52-week low values were sorted from least to greatest. The median percent above 52-week low of all companies was approximately 19.2%, while the median percent above 52-week low of the bottom companies was approximately 38.7%. This implies the companies in Chart 2 have anywhere between 12% and 35% downside potential should they converge to the overall median. Everything always reverts to the mean/median.

Chart 2. Bottom Companies By Percent Above 52-Week Low

METRIC 2. DIVIDEND YIELD

Dividend yield values were sorted from greatest to least. The median dividend yield of all companies was approximately 2.7%, while the median dividend yield of the bottom companies was approximately 1.2%. This means the companies in Chart 3 could yield approximately $15,000 less in dividends than the median company over a ten year period assuming an initial investment of $100,000 and excluding the benefit of compounded dividends.

Chart 3. Bottom Companies By Dividend Yield

METRIC 3. EARNINGS PAYOUT RATIO

Earnings payout ratio values were sorted from least to greatest. The median earnings payout ratio of all companies was approximately 44.6%, while the median earnings payout ratio of the bottom companies was approximately 66.9%. While the overall median earnings payout ratio is well below the range where most dividend investors start to worry, the bottom companies are flirting with, and exceeding, the upper range of payout levels that generally make investors uncomfortable.

Chart 4. Bottom Companies By Earnings Payout Ratio

METRIC 4. PRICE TO EARNINGS

Price to earnings values were sorted from least to greatest. The median price to earnings of all companies was approximately 18.4, while the median price to earnings of the bottom companies was approximately 24.1. This means the companies in Chart 5 are approximately 1.3 times more expensive by price to earnings than the median company, which currently trades below the S&P 500's approximate 19.7 price to earnings.

Chart 5. Bottom Companies By Price To Earnings

METRIC 5. PRICE TO SALES

Price to sales values were sorted from least to greatest. The median price to sales of all companies was approximately 2.3, while the median price to sales of the bottom companies was approximately 4.1. This means the median company is approximately 180% as expensive by price to sales than the companies in Chart 6.

Chart 6. Bottom Companies By Price To Sales

METRIC 6. PRICE TO BOOK

Price to book values were sorted from least to greatest. The median price to book of all companies was approximately 3.4, while the median price to book value of the bottom companies was approximately 7.7. This means the companies in Chart 7 are approximately 2.3 times as expensive by price to book than the median company.

Chart 7. Bottom Companies By Price To Book

CONCLUSION

Only 12 of the 30 companies managed to survive this analysis with at least one total cumulative point, meaning 18 ended with zero or fewer cumulative points. The distribution of cumulative points for all six metrics can be seen in Chart 1 above and Table 2 below.

Table 2. Cumulative Point Distribution

Points

Companies

4

1

3

2

2

3

1

6

0

6

-1

6

-2

3

-3

2

-4

1

Click to enlarge

The three DJIA companies which cumulatively under ranked their 27 peers are available in Table 3 below.

Table 3. The 3 Most Overvalued DJIA Companies

Points

Symbol

Company

-4

MRK

Merck & Co. Inc.

-3

KO

The Coca-Cola Company

-3

NKE

Nike, Inc.

Click to enlarge

But Doug, wait a minute, I thought you recommended purchasing The Coca-Cola Company in Coca-Cola: Don't Miss Out Like I Did, and now you are saying it is overvalued? What gives? That's right, I did. And when I wrote that article at the beginning of 2014 I felt KO was undervalued, purchased it and am now sitting on a nice 8.2% return, excluding dividends, in just over half a year. But I'm not buying any more KO at today's prices, which brings me to Merck & Co. Inc.

Merck & Co. Inc.

As the title of this article insinuates, I am long Merck. I originally purchased shares of Merck back in 2010 as one of my original eight stock investments. Admittedly, I mistakenly identified MRK as a Dividend Aristocrat, when it in fact it was not. Oh well, the rest of the companies I purchased I identified correctly. I have not increased my position in Merck since my original investment in 2010 when MRK was yielding approximately 4.3% and am currently sitting on a nice 64.9% gain, excluding dividends, over the last four years almost to the day.

I have not opted to DRIP any of my investments that are eligible, all of which happen to be, but instead choose to accumulate my dividends in aggregate, along with any additional capital I contribute, and reinvest or make new purchases selectively. This selective approach requires constant evaluation of current valuations like those discussed above in this article.

When deciding where to deploy my capital I ask my current investments, "what have you done for me lately?" and potential investments, "what are you going to do for me?" In the case of MRK, I feel its capital appreciation has been very satisfactory but its dividend growth has been stagnant at worst and wimpy at best.

Merck was paying a $1.50 dividend per share in 2004, a $1.52 dividend per share during 2005 through 2010, and began increasing its dividend per share to my estimated annual dividend of $1.77 in 2014. All of this is to say MRK has managed to increase its dividend by only 1.7% compounded annually over the last decade! Compare this to Chevron's 10.7% compound annual growth rate I discussed in the article I linked to at the top of this article and you start to appreciate how low 1.7% really is.

Table 4. Merck & Co. Inc. Dividend History

Year

Dividend

2014*

$1.77*

2013

1.73

2012

1.69

2011

1.56

2010

1.52

2009

1.52

2008

1.52

2007

1.52

2006

1.52

2005

1.52

2004

1.50

Total

18.0%

CAGR

1.7%

Click to enlarge

*The total 2014 dividend is estimated assuming MRK makes the September/October payment they just announced and only increase their dividend by a just penny like they have in December in each of the last two years.

Combine Merck's low dividend growth with its current 115% earnings payout ratio and you start to wonder if MRK will have to reduce its dividend. Further, Merck is the single most expensive DJIA company by price to earnings, by nearly double, and twice as expensive as the median DJIA company by price to sales. Thankfully, Merck has been excellent at generating tremendous amounts of free cash flow over the last few years, averaging around only a 50% free cash flow payout ratio. If Merck did not have a history of strong free cash flow, I would likely be selling or shorting MRK in today's market. In conclusion, I am content to hold MRK for now but will not personally, nor can I recommend others to, be a buyer of MRK today.

Think Merck & Co. Inc. is actually undervalued because of potential blockbusters in its pipeline or perhaps my analysis along with pipeline concerns are great indicators to avoid or hold MRK for now? Comment below!

Disclosure: The author is long JNJ, KO, MCD, MRK, T, VZ. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.