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By Mark Bern, CPA CFA

CVS Caremark (NYSE:CVS) is the second largest pharmacy (by sales) and the second largest pharmacy benefits manager (PBM) in the U.S. The company has over 7,000 drugstores in 44 states, the District of Columbia and Puerto Rico. At the current price of $42.01 (3:12 p.m. on January 13, 2012) the stock price appears fully valued. The current price to earnings ratio is very near the historical average of 17. The dividend is skimpy with a yield of just 1.5%, but that is also typical of a growth company. But there is some very good news to consider as well.

Over the past five years CVS earnings per share and cash flow per share have grown at average annual rates of 17% and 15%, respectively. Dividends have risen on average 18.5% over the same period. Yet the payout ratio is still a very conservative 17% of net income, based upon estimated earnings for 2011. The company has been increasing the payout ratio gradually and I believe that the end target is going to be closer to 25%. That leaves a lot of room for the dividend to grow over the next few years. So, even though we are starting from a relatively low yield, the yield on investment at today's price should look very nice by 2016 (about when I expect the payout expansion to be completed).

CVS's PBM has won some substantial new contracts and appears to be positioned for increased growth over the next few years. Also, if healthcare reform eventually takes effect, the results should actually benefit CVS as more prescriptions are moved to generics sooner and the profit margins are higher for the retailer on generics than on branded drugs. Whether reform happens or not there are a significant number of blockbuster drugs coming off patent over the next two years and that means there will be a shift to more generics. Either way, CVS should be a winner.

I expect earnings per share to increase on average about 18% per year going forward with dividends increasing at more than 20% per year on average. While the shares may not be a bargain the current price does not represent an over-valuation.

If you like the appreciation potential but need more yield consider buying the stock and selling covered call options, a very widely used method of enhancing the return on a dividend-paying stock. Historically about 80% of all option contracts expire worthless. That means that the buyers lose 80% of the time and the sellers win by the same margin. I like those odds. Use a discount online broker and you can sell an option contract for a commission of less than $10, so doing so several times a year still doesn't make much of a dent in your profits. Let's look at an example from today's options available on CVS.

I like the May 2012 call option with a strike price of $45 selling at a premium of $0.96 per share. What this means is that if you sell one contract you will receive $96 ($0.96 x 100 shares) less the commission ($10) to net $86. The expiration date of the contract is May 18, 2012 so your return is 2.1% for just over four months or an annualized return of about 6%. You should be able to duplicate this process about three times per year to net approximately $258 on 100 shares. Add that to the dividend and your cash yield for holding the stock is about 7.5%.

If the stock rises too fast you would be obligated to sell the stock for the strike price of $45 and pocket the gain of about 9% over that four month period. Not great, but that's not a bad return when annualized; about 27%. And you can start over by buying the stock again. The tax treatment on short-term trades is rough (ordinary income), so the idea is to sell calls far enough out of the money and with relatively short durations so that they don't get exercised. This is a stock you want to hold for the long term anyway; it's not one you want to trade. Remember, you're only likely to have your stock called away about 20% of the time if you use the right expiration and strike price combos.

Of course, there's nothing wrong with buying a stock like this and holding it for the long term without the options as long as you don't need the extra income. CVS is a keeper in my opinion.

If you are just interested in reading about other companies that consistently raise their dividends, you can find a list of focus articles at this link here.

Source: CVS Caremark: Excellent Growth Potential And A Rising Dividend