We Wouldn't Be Too Quick To Buy Merck & Co., Inc. (NYSE:MRK) Before It Goes Ex-Dividend

It looks like Merck & Co., Inc. (NYSE:MRK) is about to go ex-dividend in the next 4 days. The ex-dividend date occurs one day before the record date which is the day on which shareholders need to be on the company's books in order to receive a dividend. The ex-dividend date is important as the process of settlement involves two full business days. So if you miss that date, you would not show up on the company's books on the record date. This means that investors who purchase Merck's shares on or after the 17th of June will not receive the dividend, which will be paid on the 8th of July.

The company's next dividend payment will be US$0.77 per share, on the back of last year when the company paid a total of US$3.08 to shareholders. Based on the last year's worth of payments, Merck stock has a trailing yield of around 2.3% on the current share price of US$131.84. Dividends are an important source of income to many shareholders, but the health of the business is crucial to maintaining those dividends. That's why we should always check whether the dividend payments appear sustainable, and if the company is growing.

Check out our latest analysis for Merck

Dividends are typically paid out of company income, so if a company pays out more than it earned, its dividend is usually at a higher risk of being cut. Merck paid out a disturbingly high 325% of its profit as dividends last year, which makes us concerned there's something we don't fully understand in the business. Yet cash flow is typically more important than profit for assessing dividend sustainability, so we should always check if the company generated enough cash to afford its dividend. It paid out more than half (68%) of its free cash flow in the past year, which is within an average range for most companies.

It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Merck fortunately did generate enough cash to fund its dividend. If executives were to continue paying more in dividends than the company reported in profits, we'd view this as a warning sign. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.

Click here to see the company's payout ratio, plus analyst estimates of its future dividends.

Have Earnings And Dividends Been Growing?

Companies with falling earnings are riskier for dividend shareholders. If business enters a downturn and the dividend is cut, the company could see its value fall precipitously. Merck's earnings per share have fallen at approximately 17% a year over the previous five years. When earnings per share fall, the maximum amount of dividends that can be paid also falls.

The main way most investors will assess a company's dividend prospects is by checking the historical rate of dividend growth. In the last 10 years, Merck has lifted its dividend by approximately 6.0% a year on average. That's intriguing, but the combination of growing dividends despite declining earnings can typically only be achieved by paying out a larger percentage of profits. Merck is already paying out 325% of its profits, and with shrinking earnings we think it's unlikely that this dividend will grow quickly in the future.

To Sum It Up

From a dividend perspective, should investors buy or avoid Merck? Earnings per share have been shrinking in recent times. Worse, Merck's paying out a majority of its earnings and more than half its free cash flow. Positive cash flows are good news but it's not a good combination. Overall it doesn't look like the most suitable dividend stock for a long-term buy and hold investor.

So if you're still interested in Merck despite it's poor dividend qualities, you should be well informed on some of the risks facing this stock. In terms of investment risks, we've identified 4 warning signs with Merck and understanding them should be part of your investment process.

If you're in the market for strong dividend payers, we recommend checking our selection of top dividend stocks.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.