Merck: Dividend Dynamo or Disaster?

Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as Corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.

Let's see how Merck (NYSE: MRK) stacks up in four critical areas, to determine whether it's a dividend dynamo or a disaster in the making.

1. Yield
First and foremost, dividend investors like a large yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.

Merck yields 4.4% versus its industry average (of those that pay) of 3.4% -- moderately high, but certainly not cause for alarm.

2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends to the amount it generates. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford.

Merck's payout ratio is a mere 39%, which means the company can easily cover its dividend with earnings.

3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The interest coverage ratio indicates whether a company is having trouble meeting its interest payments -- any ratio less than 5 is a warning sign. Meanwhile, the debt-to-equity ratio is a good measure of a company's total debt burden.

With an interest coverage ratio of more than 10 times, and a debt-to-equity ratio of 33%, Merck's debt burden appears fairly manageable.

4. Growth
A large dividend is nice; a large, growing dividend is even better. To support a growing dividend, we also want to see earnings growth.

Let's examine how Merck stacks up next to its peers:

Source: Capital IQ, a division of Standard & Poor's. Median is of medium- and large-cap U.S. industry components.

On a per-share basis, earnings growth has been moderate, but dividend growth has been quite slow for the pharmas in recent years.

The Foolish bottom line
With a robust dividend and manageable payout ratio and debt burden, Merck demonstrates a fairly clean dividend bill of health. The only concern these numbers raise is with Merck's (and much of the pharma industry's) earnings and dividend growth-generating ability. Hopefully Merck's acquisition of Schering-Plough will help it to generate the growth dividend investors crave.