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Which Of These Pharmaceutical Giants Has The Best Dividend: Pfizer Or Merck?

April 1, 2014

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.

Dividend Yield

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 and Merck.

Pfizer 3.2%
Merck 3.2%

 

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.

Dividend Growth

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.

Pfizer 10.2%
Merck 3.0%

 

Table 2: Five-Year Dividend Growth Rates of Pfizer and Merck

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.

Company TTM 4-Year Average
Pfizer 40% 44%
Merck 51% 52%

 

Table 3: Free Cash Flow Payout Ratios of Pfizer and Merck

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 cash flow.

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.

Company 2014 2015
Pfizer 0.8% 3.1%
Merck -1.1% 7.8%

 

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 estimates.

Conclusion

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.

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WallStreetBeerMoney.com

"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"

dave@wallstreetbeermoney.com