There are a lot of things that one must consider
prior to buying stock in a publicly-traded company. Some of these
things include the strength of a company's business model,
geographic diversification, financial condition, valuation, and
potential earnings growth.
Another important concern is the dividend that the
company in question pays out. Strength and sustainability of the
dividend are very important for dividend growth investors. In fact,
did you know that 42% of the total return of the S&P 500 over the
last 80+ years came from dividends? This is why dividends are so
important for any investment portfolio.
Today, let's dig into the pharmaceutical sector and
check out the dividends from Pfizer and Merck. We will
look into the dividend history of each company, its historical
dividend growth rates, whether or not each company's dividend is
supported by cash flows, and what investors can expect from the
dividends of each company in the future.
When talking about a
company's dividend, the first thing that normally comes to mind is
the dividend yield, which is the percentage of your capital that you
receive in return over the next 12 months, as long as the dividend
amount is not changed. Here are the dividend yields from both Pfizer
Table 1: Dividend Yields Of Pfizer and Merck
There's no clear winner in this category, as the
dividend yields from both stocks are evenly matched.
The dividend yield is just one of many factors that
need to be considered when it comes to the strength of a company's
dividend. A company's stock can have a high dividend yield due to an
unsustainable dividend payout ratio, or poor fundamentals that have
brought down the stock price. These items could then lead to a
dividend cut, which will reduce your yield on cost.
Dividend growth should also be considered. This is
because a company that increases its dividend payout every year
maintains the purchasing power of the income streams that are
received by its investors. If dividend growth rates can't keep up
with inflation, then investors are really losing money when they
consider the loss in purchasing power. Dividend increases also
signal a strong outlook by management and underscores their
commitment to shareholders. Many companies regard their dividends as
a sacred cow. Over time, dividend growth can supercharge an
investor's yield on cost. Consider Warren Buffett, who started
buying Coca-Cola back in the '80s. Now, he receives a yield on cost
of 40%, and growing every year as long as Coca-Cola keeps increasing
their payout. Sounds like a pretty good deal, no?
Let's see how the dividends of Pfizer and Merck have grown over the last 5 years. The numbers in the table
represent the average dividend growth rate over the last five years.
Table 2: Five-Year Dividend Growth Rates of Pfizer
Both of these companies have shown outstanding
dividend growth rates over the last five years, easily outpacing the
erosive effects of inflation. However, Pfizer comes out
on top here with an average annual growth of 10.2%, while the growth
of Merck's dividend has just barely kept up with inflation. 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.
When it comes to dividend growth over the past five
years, Pfizer is the clear winner.
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 3: Free Cash Flow Payout Ratios of Pfizer and
Table 3 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
Forecasted Earnings Per Share Growth
Dividend growth can be driven by a couple of
different factors. One of these factors is the expansion of the
company's payout ratio, where the company decides to pay out a
higher percentage of its earnings or free cash flow to shareholders
as dividends. However, you can only expand the payout ratio so much.
Eventually, you must have free cash flow growth in order to pay
steadily increasing dividends. And, we all know that free cash flow
growth comes from earnings growth. To get a good idea as to the
prospects of a company's future dividend payments, it may behoove us
to look at analyst projections for future earnings per share growth
over the next couple of years. Table 4 shows the forecasted earnings
per share growth rates for Pfizer and Merck over the next
couple of years.
Table 4: Forecasted Earnings Per Share Growth for
Pfizer and Merck
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.
Both Clorox and Colgate-Palmolive are expected to post
solid earnings per share growth over the next couple
of years. Colgate-Palmolive, however, has slightly more favorable
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.