I’m someone who “lives” in the future a lot.
The future is constantly on my mind.
I wouldn’t necessarily consider this a bad thing, as I’m basically trying to anticipate problems and prevent them before they happen, but this does come at a cost.
The cost being, there’s a diminished ability to live in the present.
And here’s the hard truth about that: None of us are promised tomorrow.
Life is short, and enjoying what limited time we do have is of the utmost importance.
This is why I’ve been such a diligent saver and investor over the last 15 years of my life.
Saving and investing your money can “buy” time – in the sense that once you can afford to do whatever you want (without having to exchange your time for labor), you’re free to “spend” your time however you wish.
The best way to make this equation work, in my experience, is through the dividend growth investing strategy.
This is a long-term investment strategy that promotes the idea of buying and holding shares in high-quality businesses paying safe, growing dividends to shareholders.
You can find hundreds of examples by pulling up the Dividend Champions, Contenders, and Challengers list.
This list has data on all US-listed stocks which have raised dividends each year for at least the last five consecutive years.
Since it takes a special kind of operation to be able to generate the ever-larger profit necessary to sustain ever-higher dividend payments, the dividend growth investing strategy tends to effectively limit oneself to the best businesses and investments out there.
And the growing dividend income one can collect along the way can be the perfect foundation for financial independence.
I’d know firsthand.
I built the FIRE Fund – my real-money portfolio that generates enough five-figure passive dividend income for me to live off of – using the dividend growth investing strategy.
Because dividend income is able to cover my bills, I get to live on my terms.
I’ve been in this very fortunate position since I quit my job and retired in my early 30s, which is discussed in my Early Retirement Blueprint.
But dividend growth investing involves more than simply selecting the right businesses; there’s also the matter of selecting the right valuations.
And that’s because price represents what you pay, but value represents what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
None of us are promised tomorrow, which is why chasing after and achieving financial independence through the consistent buying and holding of undervalued high-quality dividend growth stocks is so vital.
Now, the whole topic of valuation seems complicated, but it’s really not.
And if it seems daunting to you, be sure to read Lesson 11: Valuation.
Put together by fellow contributor Dave Van Knapp, it describes valuation using very simple terminology and even provides an easy-to-use template that you can apply to almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Merck & Co., Inc. (MRK)
Merck & Co., Inc. (MRK)Merck & Co., Inc. (MRK) is a leading global pharmaceutical company that produces a range of medicines, vaccines, and animal healthcare products.
Founded in 1891, Merck is now a $223 billion (by market cap) healthcare mammoth that employs nearly 75,000 people.
The company operates across two reportable segments: Pharmaceutical, 89% of FY 2024 sales; and Animal Health, 9%. Insignificant sales occur as Other Revenue.
Their core areas of focus are: diabetes, infectious diseases, oncology, vaccines, and animal health.
The US is the company’s largest single market, accounting for approximately half of worldwide sales.
Some of the company’s key drugs include Keytruda, Januvia, Gardasil, and ProQuad.
Keytruda, their triumphant cancer drug, is the company’s most important product and by far the top-selling drug across the portfolio.
Keytruda is actually the best-selling drug in the world.
This single drug comprised roughly 46% of the company’s worldwide sales for FY 2024, up from 42% in FY 2023.
Here’s what’s amazing: Keytruda is not only the best-selling product for Merck but also one of its fastest-growing products.
Keytruda’s global sales were up ~18% in FY 2024, despite already coming off of a $25 billion annual sales base in the prior year.
It boggles the mind.
However, Merck is starting to become a victim of its own success.
While the company has been able to ride the Keytruda roller coaster to unprecedented heights, this ride won’t last forever.
Keytruda’s patent protection has a finite time frame, upon which time the competition will very quickly come in with their own compounds.
This will undoubtedly take away sales and share from Keytruda, in turn harming Merck as a whole.
But there are two points to keep in mind here.
First, Keytruda’s patent protection runs through 2028 in the US and EU, giving Merck some time to prepare for the slowdown that will occur as we head into the 2030s.
Second, and building on that first point, Merck continues to extend Keytruda’s runway by pursuing new clinical trials and treatment pathways for different types of cancers in order to reinforce/extend patent protection and buy time.
Moreover, and more importantly for the long-term success of the company, Merck is busy developing new compounds and building out its pipeline.
Committing more than 20,000 of its employees to R&D alone, Merck has 50+ programs in Phase II and 30+ programs in Phase III.
This means there are plenty of “shots on goal” as it pertains to developing the next blockbuster that can accept the baton from Ketyruda.
On top of the organic opportunities, Merck is also pursuing bolt-on acquisitions designed to further bolster its pipeline.
A prime example of its acquisitions strategy is its ~$10 billion acquisition of Verona Pharma PLC (VRNA), a UK biotech firm specializing in respiratory diseases, which was announced in July.
With global demographics – the world is growing larger, older, and richer simultaneously – creating rising demand for high-quality, cutting-edge healthcare, which plays right into the hands of a major pharmaceutical company like Merck, there is much to be excited about over the coming years.
Despite Keytruda’s oncoming patent cliff, Merck is positioned to continue growing its revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Merck has increased its dividend for 14 consecutive years.
Its 10-year dividend growth rate of 5.4% is only decent, but one can’t necessarily fault Merck for being somewhat conservative around dividend raises as it prepares for the impending Keytruda patent cliff and invests for the next phase of growth.
What’s more than decent, however, is the stock’s yield, which is currently sitting at a market-beating 3.8%.
That goes a long way toward making up for the middling dividend growth.
By the way, this yield is 80 basis points higher than its own five-year average, so investors today are getting compensated nicely (and more nicely than usual) for the near-term uncertainty regarding Keytruda.
With the payout ratio sitting at exactly 50%, Merck is perfectly balancing rewarding shareholders against the need to retain capital for reinvestment.
In an expensive, income-starved market, Merck’s healthy dividend offers plenty of appeal.
Revenue and Earnings Growth
As appealing as all of this may be, though, the dividend picture is largely written by the past.
However, investors must always be thinking about the future, as the capital of today gets risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when later estimating fair value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should give us the information necessary to evaluate where the business could be going from here.
Merck increased its revenue from $39.5 billion in FY 2015 to $64.2 billion in FY 2024.
That’s a compound annual growth rate of 5.5%.
Very respectable top-line growth out of a large, mature pharmaceutical firm.
Revenue moved very little between FY 2015 and FY 2020, but it hit a serious inflection point in FY 2021.
After initially being approved by the FDA in 2014 and growing its treatment applications thereafter, Keytruda really started moving around 2020 – carrying all of Merck with it.
Meanwhile, earnings per share grew from $1.56 to $6.74 over this period, which is a CAGR of 17.7%.
Extremely impressive, but it’s not totally accurate and indicative of the true growth profile.
EPS has been super lumpy, depending on charges Merck takes in any given year in order to account for development and other impacts, and different starting/ending points will yield vastly different results.
That said, we clearly have an indication of just how much influence Keytruda has had on the firm’s ability to grow and expand its profitability.
Speaking of expanding profitability, it was drastic margin expansion that helped to drive a lot of excess bottom-line growth, although Merck has also been active around buybacks over this period (reducing its outstanding share count by more than 10%).
Looking forward, CFRA is projecting that Merck will compound its EPS at an annual rate of 4% over the next three years.
CFRA highlights recent moves in its cardiopulmonary portfolio, including a 2024 approval for Winrevair (a treatment for pulmonary arterial hypertension in adults) and the aforementioned acquisition of Verona Pharma, as reasons to be enthusiastic over the near term, even though the Keytruda patent cliff looms large.
Speaking more on this, CFRA does a good job of summing up the situation for Merck: “We expect Keytruda, [Merck]’s blockbuster oncology treatment to continue be the top-selling drug worldwide in the near-term, but we expect its sales to start trending down in 2026 as we are approaching the 2028 loss of expiry in the key U.S. market. [Merck]’s sales continues to be concentrated on Keytruda, which makes up roughly half of its sales. Yet, we see value in [Merck]’s cardiology and oncology drug portfolios, and think [Merck] is well diversified.”
That pretty much sums it up.
The loss of exclusivity around Keytruda will hurt, but Merck has a valuable and growing portfolio of drugs to cushion some of the impact and position the firm to resume growth into the 2030s.
If one is investing for the next year or two, Merck is not ideal by a long shot.
However, for long-term investors who can imagine what the next decade or two might look like, Merck has a lot going for it.
With CFRA’s near-term forecast calling for mid-single-digit growth, I would expect the dividend to roughly mirror this, but moving past the upcoming post-LOE air pocket could set the dividend up for faster growth.
It’ll take a few years for that stabilization to realize itself, but patient investors stand to be rewarded (and collect a near-4% yield along the way).
Financial Position
Moving over to the balance sheet, Merck has a good financial position.
The long-term debt/equity ratio is 0.7, while the interest coverage ratio is over 16.
The latter number was helped by an extraordinary FY 2024 on the EBIT side, but the interest coverage ratio does tend to stay over 10.
Merck finished last year with nearly $35 billion in long-term debt, which, while not unsubstantial in absolute terms, is not overly cumbersome for a company of its size.
The company also maintains investment-grade credit ratings: Aa3, Moody’s; A+, S&P.
Profitability is robust.
Return on equity has averaged 29% over the last five years, while net margin has averaged 19.1%.
Again, there’s been some lumpiness here, but the margin expansion story has been prolific; whereas net margin was routinely in the 10% area a decade ago, it’s more recently been over 20%.
Merck is one of the biggest and best pharmaceutical firms in the world.
And with economies of scale, a global distribution network, patents, IP, and R&D, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
All three of these risks are elevated in this particular industry, in my view, particularly regulation (because Merck must go through strict regulatory bodies in order to get drugs approved and put on the market).
Patent cliffs are one of the biggest risks for any pharmaceutical company, and Merck is especially exposed to this risk with Keytruda, but the company has an extensive pipeline to work through and develop while its most important drug is still under patent protection.
If Merck is unable to fill the hole that Keytruda’s LOE will create, this could lead to severe consequences as it relates to performance across both the business and stock.
Any large changes to the complex US healthcare system would likely directly impact Merck.
The company’s international footprint exposes it to geopolitics and currency exchange rates.
There are execution and integration risks with consistent bolt-on acquisitions, and management must be prudent around deal research and valuations.
I see plenty of risks present, many of which are common for the business model, and some of which are specifically related to the Keytruda LOE.
But the market has already sniffed all of this out and assigned the stock a low valuation, which is exactly where the long-term investment opportunity may be…
Valuation
The stock’s P/E ratio is just 13.5.
Admittedly, TTM EPS is at a higher-than-usual level (as noted earlier, EPS is lumpy), making this look even better.
However, this is well below the stock’s own five-year average P/E ratio of 22.2 – and that average accounts for the oscillations.
The sales multiple of 3.5, which is more accurate (since revenue is more “true”), is also quite a bit lower than its own five-year average of 4.2.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 6.5%.
This growth rate is on the lower end of what I normally allow for, and I think it appropriately considers the modest dividend growth over the last decade and muted near-term growth outlook.
That said, under normal conditions, a business as good as Merck should easily be able to grow its dividend at this rate (or higher), and a lot of the modest dividend growth over the last decade is due to prudence and an acknowledgment that investment into a post-LOE (on Keytruda) future is critical.
Once Merck is past this LOE uncertainty and the portfolio is given room to shine, the dividend should be able to get back to a more normal growth trajectory.
The DDM analysis gives me a fair value of $98.59.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I don’t see massive undervaluation being present, although the stock also doesn’t appear to be properly appreciated right now.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates MRK as a 4-star stock, with a fair value estimate of $111.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates MRK as a 4-star “BUY”, with a 12-month target price of $98.00.
I’m almost precisely in line with CFRA on this one. Averaging the three numbers out gives us a final valuation of $102.53, which would indicate the stock is possibly 15% undervalued.
Bottom line: Merck & Co., Inc. (MRK) is a world-class pharmaceutical firm which controls the best-selling drug on the entire planet. Through diligent acquisitions and careful pipeline development, the company is positioning itself for the future. With a market-beating yield, inflation-beating dividend growth, a perfectly balanced payout ratio, nearly 15 consecutive years of dividend increases, and the potential that shares are 15% undervalued, long-term dividend growth investors looking for an inexpensive opportunity in an expensive market have a clear shot on goal.
-Jason Fieber
Note from D&I: How safe is MRK‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 90. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, MRK‘s dividend appears Very Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Source: Dividends & Income
Disclosure: I’m long MRK.
