Understanding The Dividend Growth Income+ Club Approach

Total Return, Dividends, Share Price

Undertaking exercises to determine the current value of a stock is a waste of time, when the market continually provides the only current value that matters when it comes to buy a stock. The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price – the only way. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.

Merck Investment Review: Short-term Outlook To End Of 2022

I recently conducted a review of the four pharma companies in the DGI+ Club database of 127 tickers, including Merck & Co., Inc. (MRK). The stocks in the database are all dividend payers and include the dividend aristocrats. These are all quality stocks and reviews are concentrated on identifying those stocks likely to provide superior returns due to share mispricing as a result of current distortion to market metrics.

At current share price levels, Merck, with potential for up to mid-teens returns, appears to offer good value, but with a perceived significant degree of downside risk, for investment through the end of 2022. Taking into account the downside risk, Merck does not offer sufficiently high returns compared to our top pharma pick, in a market where we believe there is considerable mispricing of stocks at this time, due to COVID-19 disruption of businesses. Summarized in Tables 1.1 and 1.2 below is relevant data on historical and projected performance for Merck.

Table 1.1 Historical and projected performance

Table 1.1 summarizes historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2022 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note estimates are shown for analysts EPS estimates out to 2024 where available but these are considered not as reliable). Table 1.1 allows modeling for target total rates of return. In the case shown above, the target set for a total rate of return is 7% per year, based on buying at Thursday, September 17, closing share price level.

Table 1.1 shows the required average yearly share price growth rate from September 16, 2020, through December 31, 2022, to achieve the 7% return is 3.77%. This growth rate is lower than the target 7% return due to estimated dividends receivable. Merck has a dividend yield of 2.88% at current share price, so the balance of the 7% targeted return has to come from the share price growth rate. Table 1.2 below summarizes relevant data for Merck, flowing from the assumption of a target 7% total return.

Table 1.2 Summary of relevant projections

Table 1.2 provides relevant data, assuming share price grows at rates sufficient to provide a total rate of return of 7%, for buying at closing share price on September 17, 2020, and holding through the end of 2022. All EPS estimates are based on analysts’ consensus and low estimates per SA Premium. The data in Table 1.2 is drawn from Table 1.1 and the further analyses and scenarios in Tables below.

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Merck Analysis

Table 2.1 Based on analysts’ consensus EPS estimates

Table 2.1 shows the detail of the projections for investment in Merck shares through the end of 2022, per Cases 1.1 and 1.2 in Table 1.2 above. Case 1.2 shows the return of 14.6% indicated if the P/E ratio increases back to the 15.87 level on February 21, 2020. Table 2.1 also shows projections for buying Merck shares at the current price level and holding for longer periods from 4.25 years out to 40 years. Note the EPS growth rate of 4.00% for 2023 and beyond is an arbitrary estimate, and there is no certainty EPS will continue to grow at this rate. However, a 4.00% EPS growth rate, together with the starting dividend yield of 2.68%, would provide a long-term total return of ~7.0% per year.

Table 2.2 Based on analysts’ low EPS estimates

Table 2.2 shows the detail of the projections for investment in Merck shares through the end of 2022, per Cases 2.1 and 2.2 in Table 1.2 above. The returns at the end of 2022 of 7% and 14.6% at the high EPS estimates become returns of negative (5.3)% and 1.4% at the low EPS estimates. This potential for losses, if the analyst providing the low EPS estimate turns out to be correct, is of considerable concern. Such a wide disparity between the low and the consensus EPS estimate suggests a high degree of uncertainty among analysts in their estimations of the future earnings of Merck. It suggests the potential 14.6% return based on the consensus EPS estimate is subject to above-average risk. The difference in results through end of 2022 between Cases 2.1 and 2.2 in Table 2.2 is entirely due to the difference in assumed P/E ratio levels at the end of 2022. For Case 2.1, an ending P/E ratio of 13.57 results in a negative return of (5.3)%, and for Case 2.2, an ending P/E ratio of 15.87 results in a return of 1.4%. These P/E ratios compare to a higher average P/E ratio of 16.21 for the period 2016 to 2019, per Table 1.2 above. Longer term total returns in the order of 7% are driven by the assumed EPS growth rate of 4.0% from 2023 onwards, and the dividend yield at purchase of 2.88% per Table 1.2 above. Unlike EPS growth rates, which are cumulative, a change in P/E ratios has a one-off effect which has minimal effect over long periods of time. Overpay for a stock with a continuing high EPS growth rate, and time invested will mostly heal the wound. Table 2.3 below shows the result of increasing the P/E ratio to the 2026 to 2029 average of 16.21, and also demonstrates the impact of high EPS growth rates over long periods of time.

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Table 2.3 Based on analysts consensus EPS estimates and 2016 to 2019 average P/E ratio

Table 2.3 assumes long-term average EPS growth rate of 4% for Case 3.1, and 12% for Case 3.2. It is also assumed, as with all other cases, dividends are reinvested. It is further assumed the dividend payout ratio is constant throughout, so dividends grow at the same rate as EPS.

Comments on Case 3.1 –

Case 3.1 has similar assumptions to Case 1.1 in Table 2.1 above, except the P/E ratio has been increased to the 2016 to 2019 average of 16.21. The result at the end of 2022 is an increase in the projected rate of return from 7.0% to 15.7%. This increase in return is entirely due to the assumed increase in P/E ratio. The return at the end of 40 years is virtually unchanged at ~7%. As discussed further above, changes in P/E ratio have a one-off effect, which can be quite large, and significantly affect rate of return in the short term. Over the very long term, this one-off effect has only minor impact on total rate of return.

Comments on Case 3.2 –

Case 3.2 has similar assumptions to Case 1.2 in Table 2.1 above, except the P/E ratio has been increased to the 2016 to 2019 average of 16.21, and the long-term EPS growth rate from 2023 onwards has been increased from 4% to 8%. The result at the end of 2022 is an increase in the projected rate of return from 14.6% to 15.7%. This increase in return is entirely due to the assumed increase in P/E ratio. As noted for Case 3.1 the return at the end of 40 years will be minimally affected by the increase in the P/E ratio. But the doubling of the EPS growth rate from 4% to 8% results in a close to quadrupling in the ending investment value from $15,763 for Case 1.2 to $62,088 for Case 3.2. This impact of the power of compounding increases exponentially with increases in either or both of the period invested and the growth rate.

I have heard it said, “youth is wasted on the young.” The corollary to that could be, “investing is wasted on the old,” because the old do not have the same long time horizon available to the young to take advantage of the full power of compounding. On the other hand, Warren Buffett could point out at 50 he had all the time he needed, and he has the runs on the board to prove it.

Merck: Summary and Conclusions

The short term through end of 2022

The market appears to be having difficulty with rationally setting share prices at present due to the distortion of usual market metrics by the impacts of the COVID-19 pandemic. On a range of measures, Merck appears to offer the possibility of positive returns in the low double-digits, in the short term through the end of 2022. At the same time the low end of analysts’ EPS estimates suggests the risk of considerable downside potential. Here at DGI+ Club, we are working through a database of 127 dividend-paying stocks, including the dividend aristocrats, and there are other stocks in the healthcare pharma sector offering higher returns in the short term due to market mispricing, and with less perceived downside risk. One of those stocks has an indicative return potential of over 30% through end of 2022.

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The long term going out 10, 20, 30 and 40 years

“It’s tough to make predictions, especially about the future.” Yogi Berra.

That is an enduring truism that applies to long-term EPS growth rates for Merck as well as all other businesses we might look at. We can mainly look at past history, and a limited period into the future, where there can be reasonable projections based on currently-known information. Per Table 1.2, Merck achieved EPS growth for 2016 to 2019 of 11.15%, and 9.80% growth is projected based on analysts’ consensus estimates for 2019 to 2022. That makes the 8% long-term EPS growth rate per Case 3.2 in Table 2.3 seem reasonable. The major concern is the negative EPS growth rate for 2019 to 2022 based on analysts’ low EPS estimates for Merck.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.



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