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Merck & Co Inc. (NYSE:MRK) is a large pharmaceutical company that manufactures products, which treat a wide range of conditions. Its consumer products division has well-known brands such as Claritin and Dr. Scholls. The company also sells a variety of vaccines. The largest competitors for Merck are Pfizer Inc. (NYSE:PFE) and Eli Lilly and Company (NYSE:LLY).

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MRK Chart

MRK data by YCharts

Merck currently trades at $41.51 per share and has a 4.05% dividend yield. Pfizer has a similar yield of 3.9%, while Eli Lilly has a higher yield of 4.59%. Of course, yield is only one half of the dividend picture. Equally important for any dividend stock is the dividend growth rate. Here is the ten-year dividend history for Merck.

YearDividendGrowth
2002$1.422.90%
2003$1.462.82%
2004$1.502.74%
2005$1.521.33%
2006$1.520.00%
2007$1.520.00%
2008$1.520.00%
2009$1.520.00%
2010$1.520.00%
2011$1.562.63%

Merck's dividend growth has been abysmal. In years where the dividend grew, it was by less than 3%, and 5 out of 10 years, the dividend didn't grow at all. By contrast, Pfizer has grown its dividend at a much higher rate over the past 10 years, which I pointed out in my article on Pfizer here. I'll calculate the payout ratio as a percentage of free cash flow. The results are shown below.

YearFree Cash Flow (Mil $)Float (Mil Shares)Payout Ratio
2002$7,1592,27745.16%
2003$7,9472,25341.39%
2004$7,0732,22647.21%
2005$6,2062,20053.88%
2006$5,7852,18857.49%
2007$5,9882,19355.67%
2008$5,2732,14561.83%
2009$1,9312,273178.92%
2010$9,1443,12051.86%
2011$10,6603,09445.28%

The payout ratio has consistently hovered around 50%, with the exception of 2009, and this value is completely reasonable and sustainable.

Valuation

I will use the Dividend Discount Model to put an estimated value on the company. This model assumes that the value of a company is purely the sum of all future dividends discounted back today. This is a reasonable valuation method if you are a dividend investor. The discount rate should be your required rate of return, and I will use a discount rate of 8%, which is roughly the long-term growth rate of the market as a whole. I will assume that the dividend will grow at a rate of 3% in perpetuity. Using these parameters, I arrive at a fair value estimate of $32.14 for a share of Merck.

Conclusion

Merck has a high yield of just over 4%, but almost nonexistent dividend growth. The graphic below shows how both yield and growth combine to determine the value of the stock.

For Merck to be fairly valued, the dividend would have to grow at a rate of about 5.5%, which is well above the historical rate. At about $42 a share, Merck is significantly overvalued and is a stock that dividend investors should stay away from. Pfizer is a far better choice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.