Here's Why We're Wary Of Buying Merck's (NYSE:MRK) For Its Upcoming Dividend

Readers hoping to buy Merck & Co., Inc. (NYSE:MRK) for its dividend will need to make their move shortly, as the stock is about to trade ex-dividend. The ex-dividend date is one business day before a company's record date, which is the date on which the company determines which shareholders are entitled to receive a dividend. The ex-dividend date is important because any transaction on a stock needs to have been settled before the record date in order to be eligible for a dividend. Therefore, if you purchase Merck's shares on or after the 15th of September, you won't be eligible to receive the dividend, when it is paid on the 7th of October.

The company's upcoming dividend is US$0.85 a share, following on from the last 12 months, when the company distributed a total of US$3.40 per share to shareholders. Based on the last year's worth of payments, Merck has a trailing yield of 2.3% on the current stock price of US$147.53. If you buy this business for its dividend, you should have an idea of whether Merck's dividend is reliable and sustainable. So we need to check whether the dividend payments are covered, and if earnings are growing.

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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 259% of its profit as dividends last year, which makes us concerned there's something we don't fully understand in the business. Yet cash flows are even more important than profits for assessing a dividend, so we need to see if the company generated enough cash to pay its distribution. Dividends consumed 52% of the company's free cash flow last year, which is within a normal range for most dividend-paying organisations.

It's good to see that while Merck's dividends were not covered by profits, at least they are affordable from a cash perspective. If executives were to continue paying more in dividends than the company reported in profits, we'd view this as a warning sign. Very few companies are able to sustainably pay dividends larger than their reported earnings.

Check out our latest analysis for Merck

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 earnings decline and the company is forced to cut its dividend, investors could watch the value of their investment go up in smoke. Merck's earnings per share have fallen at approximately 6.4% a year over the previous five years. Ultimately, when earnings per share decline, the size of the pie from which dividends can be paid, shrinks.

Many investors will assess a company's dividend performance by evaluating how much the dividend payments have changed over time. Merck has delivered 6.3% dividend growth per year on average over the past 10 years. The only way to pay higher dividends when earnings are shrinking is either to pay out a larger percentage of profits, spend cash from the balance sheet, or borrow the money. Merck is already paying out 259% of its profits, and with shrinking earnings we think it's unlikely that this dividend will grow quickly in the future.

The Bottom Line

Is Merck worth buying for its dividend? It's never fun to see a company's earnings per share in retreat. What's more, Merck is paying out a majority of its earnings and over half its free cash flow. It's hard to say if the business has the financial resources and time to turn things around without cutting the dividend. Overall it doesn't look like the most suitable dividend stock for a long-term buy and hold investor.

With that being said, if you're still considering Merck as an investment, you'll find it beneficial to know what risks this stock is facing. Every company has risks, and we've spotted 5 warning signs for Merck you should know about.

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.