In this series, High Quality Dividend Growth Stock of the Month, I cover really great companies.

To identify them, I use my Quality Snapshot grading system. In a nutshell, here’s how the system works.

First, I obtain five quality ratings from the following sources.

Then I assign between 0 and 5 points to each factor according to the following table.

Finally, the Quality Snapshot score for a company is the total of its points, so the highest possible score is 25 points. This is how I interpret the QS scores.

High Quality Dividend-Growth Stock for May, 2021: Merck (MRK)

Merck (MRK), headquartered in New Jersey, is an international pharmaceutical giant. Its business lines are pharmaceuticals, vaccines, and animal health.

Founded in 1891, Merck has a long list of historic advances to its credit, including the synthesis of vitamin B1 in 1936; of cortisone in 1950; the development of the MMR (measles, mumps, rubella) vaccine in 1971; first pneumonia vaccine in 1977; and introduction of the first commercial statin in 1987.

Merck today employs 74,000 employees. It considers the following to be its key growth pillars:

(Source of all slides: Investor presentations)

Over the years, Merck has grown both organically and through acquisitions. It completed 120 business development transactions in 2020. In 2021, Merck has acquired Pandion Therapeutics, a biotechnology company developing novel therapeutics for patients with autoimmune diseases. Merck has also entered a collaboration agreement with Gilead Sciences to jointly develop and commercialize long-acting HIV treatments.

Despite the pandemic, Merck registered healthy growth in 2020.

In February, 2021, Merck announced plans to spin off its Women’s Health and Biosimilar divisions, along with various legacy branded drugs. Combined, these businesses account for nearly 15% of Merck’s revenue.

The new company will be called Organon, which will trade separately (under the ticker symbol OGN. The spin-off is expected to be completed in June.

When it is spun off, Merck shareholders will receive 1/10th share of OGN for each share of Merck that they own as of May 17. Fractional shares will not be distributed, so partial shares of OGN will be paid off in cash, which Merck is calling a special dividend.

After the spinoff, Merck will be fairly dependent on a relatively small number of drugs, with about 45% of revenue coming from three brands.

Merck will need to continue to build its R&D pipeline to eventually replace its oncology drug Keytruda, its largest brand, which brings in about ¼ of Merck’s revenue. Keytruda’s patent protection lasts until 2028, so there is time to do that. The other two top brands are Gardasil (8% of revenue, 2028 patent loss in USA) and Januvia (7% of revenue, 2022 loss of patent protection).

Merck’s High Quality

Here is how Merck stacks up on the Quality Snapshot system described at the beginning of this article.

Merck gets the highest rating on every factor. That puts Merck in rare territory: There are fewer than a dozen companies that I have encountered that score 25 out of 25 points on their Quality Snapshots.

Simply Safe Dividends reaffirmed Merck’s dividend safety score of 99 / 100 on February 10, 2021, following the company’s full-year 2020 earnings report.

Merck’s Dividend Record

Merck yields 3.3%, which I consider to be Above Average among all dividend-growth stocks.

Its dividend growth history is not long, at 10 years, although Merck has paid an annual dividend every year for over 30 years. The company froze its dividend 2005-11.

The size of Merck’s dividend increases during its 10-year streak has ranged from low (in the 2% range) to high (double-digits). Its 2021 increase is 6.6%, which is slightly higher than its 5-year average.

Overall, that combination of 3.3% yield and 6% annual growth makes Merck a mid-yield, mid-growth DG stock.

Scoring at home, I give Merck an overall grade of B for its dividend record.

I always like it when a company publicly states its commitment to its dividend. Merck has done so consistently in its recent presentations.

The following display from Simply Safe Dividends shows Merck’s dividend record from before the beginning of its increase streak. Note the flat period from 2005-2011, when Merck simply held its dividend steady for seven straight years. The chart does not yet reflect Merck’s 6.6% increase earlier this year.

Merck’s Valuation

To value a stock, I use four valuation models, then average them. For more details, see Dividend Growth Investing Lesson 11: Valuation.

Models 1 and 2: FASTGraphs P/E Benchmarks

FASTGraphs present a stock’s price on the same chart as valuation reference lines for easy comparison. I use two reference lines to denote fair value.

  • A magenta line based on a standard P/E ratio for “the market” that I set at 18 for most stocks. That reflects average market P/Es over the past 20-30 years.
  • A blue reference line based on the stock’s own P/E ratio for the past 5 years. For MRK, that 5-year average P/E has been 15.5.

Here is the FASTGraph for MRK using an 8-year display period. I use the 8-year display because it causes FASTGraphs to use the stock’s 5-year average P/E for the blue line.

The black line is MRK’s actual market price.

As you can see, Merck’s actual price is well below both of the fair-value reference lines.

MRK’s stock is in a “dead money” phase: Its price today is basically the same as it was two years ago, even though the company has registered strong earnings growth (see the highlighted annual increases in EPS).

The combination of flat price during a period of rising earnings is one of my favorite scenarios in which to buy a stock. The combo has caused MRK’s P/E ratio to contract from 18.4 in November 2018 to 12.7 today.

To quantify all this, I create valuation ratios that relate the stock’s actual current P/E to the two reference lines.

Valuation ratio #1 (magenta line)  = 12.7 / 18  = 0.71

Valuation ratio #2 (blue line) = 12.7 / 15.5 = 0.86

Both models suggest that Merck is presently undervalued, courtesy of the dead-money phase in MRK’s stock.

Model 3: Morningstar’s Discounted Cash Flow

Morningstar takes a different approach to valuation. They ignore P/E and other common valuation ratios.

Instead, they use a discounted cash flow (DCF) model. That means that, using conservative projections, they discount all of the stock’s estimated future cash flows back to the present to arrive at a fair value estimate. The idea is that a stock’s fair price is equal to the net present value of all of the company’s future cash flows.

Here is Morningstar’s valuation of MRK. They too find the stock to be undervalued, selling at a 22% discount. (That’s the same as a valuation ratio of 0.78.)

Model 4: Current Yield vs. Historical Yield

The final model compares the stock’s current yield to its historical yield.

If a stock is yielding more than its historical average, that suggests that it is a better value than usual, because you are paying less for the stock’s dividends.

We can see the yield comparison on this graph from Simply Safe Dividends. Merck is currently yielding more than its 5-year average.

Again with this model, we make a valuation ratio. MRK’s current yield is 3.3% and its 5-year historical average is 3.0%.

Valuation ratio = 3.0% / 3.3% = 0.91

Because that is within 10% of 1.00, I call that “fairly valued.”

To arrive at my overall valuation, I average the four models.

I conclude that Merck is 18% undervalued. From there, it is easy to calculate a fair price; just divide the current price by the valuation ratio.

Merck’s recent price is about $78. So we get $78 / 0.82 = $95 for Merck’s fair price.

All valuations are estimates about the future. Therefore, it is logical to think in ranges rather than precise values.

I regard any price within +/- 10% of my calculated fair price to be “fair.”

If I apply that 10% cushion to Merck, that puts the top of its buying range at $105

Obviously, with Merck currently trading so far below its fair price, there is no need to even think about its maximum buy price. A good time to buy it is right now, at an 18% discount.

Closing Thoughts

Merck is an extremely high-quality company trading at a pretty steep discount.

The discount has been caused by Merck’s stock price going nowhere for more than two years while its earnings have been growing steadily. This kind of “dead money” situation is one of my favorite circumstances to buy stocks.

In researching this article, I could not help but notice the high ratings that Merck has from a number of different sources. For example, below is the summary of research provided by Schwab to its customers. All of the ratings except one have Merck in one of the two top categories on each provider’s rating system.

I do not currently hold Merck stock. Jason Fieber made Merck his Undervalued Dividend Growth Stock of the Week: Merck & Co. (MRK) in late March.

This article is not a recommendation to buy, sell, hold, trim, or add to Merck. As always, perform your own due diligence. Check the company’s complete dividend record, business model, financial situation, and prospects for the future. Also consider your tolerance for risk, and especially consider how well the company fits your long-term investing goals.

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