Companies have a limited number of choices when deciding what to do with the money they earn. For mature businesses with relatively predictable earnings, a portion of those earnings are often returned to shareholders in the form of dividends. Defining a great dividend stock is personal. For some, it means a low current yield but plenty of room to raise the payout in the future. For others, it might mean a stock that pays them a substantial yield now with a low probability of being cut, regardless of how much it may grow in the years ahead.
There are a few metrics that can help identify these attributes and determine if the stock deserves a place in your portfolio. They tell us what to expect in the near term and whether a company might disappoint investors who count on those dividends in the future. For Pfizer (NYSE:PFE), the dividend yield, growth rate, and payout ratio all support the same conclusion.
Although there is no commitment to pay one, once a board of directors approves a dividend, they usually don't change their minds unless there are dire circumstances. Pfizer's yield, calculated by dividing the $1.56 an investor is slated to receive this year by the current stock price, is 4.23%. That's significantly more than the 1.5% yield of the S&P 500. On this metric, the company gets a check mark as a great dividend stock.
The company recently combined its non-patented drug division with generic drug maker Mylan, calling the new entity Viatris (NASDAQ:VTRS). That division made up about 21% of 2019 sales. With the strategic shift, the company has signaled it will be less focused on the dividend going forward. Although it still has a healthy yield, other metrics might give some investors pause.
While many investors try to find stocks with high yields, others are more interested in companies that grow the yield over time. Some companies pride themselves on having increased the dividend every year for decades. If they do this for more than a quarter century they are called Dividend Aristocrats.
Pfizer hasn't earned that distinction yet. The company has only been increasing its distribution since 2010. Unfortunately, Pfizer only increased its payout from $0.38 per quarter to $0.39 per quarter this year. That meager 2.6% increase is likely to be the story for the foreseeable future.
In remarks to the recent JPMorgan Healthcare Conference, CEO Albert Bourla reiterated a focus on developing new drugs and stated that dividend growth would not increase as fast as earnings, which he expects to be at least 10% per year. For comparison, the last time Johnson & Johnson, Starbucks, and Nike raised their distributions it was 6.3%, 9.8%, and 12.2%, respectively. Pfizer gets some credit for consistently raising the payout, but it's far from a great dividend stock based on the growth rate.
There are different ways to calculate how reliable a company's payout is. Many point to the number of consecutive years the dividend is paid, but that can be a misleading metric. General Electric has paid one since 1941 but has had to cut it 10 different times including in 2000, 2009, 2018, and 2019. A better way to assess the company's ability to pay is to divide the amount of dividends being paid out by the earnings. This is called the payout ratio, and the closer the ratio gets to 100%, the riskier the dividend. If the payouts are about the same as earnings, there is less room for the company to increase the dividend and an increased risk it will have to be cut in a downturn like a recession, failed product launch, or embarrassing event that temporarily damages the brand.
For Pfizer, the payout ratio for the past 10 years is 72%. Over the past 12 months the ratio was 97%. That should raise some eyebrows among shareholders. However, after guiding for $3.05 in earnings per share for 2021, the company's payout ratio will drop back to 51% next year. The realization that Pfizer paid out nearly everything it earned over the past year is a good reminder of how an economic slowdown can affect the dividend of a company that pays out so much to shareholders.
A personal choice
Whether Pfizer is a great dividend stock boils down to why someone is purchasing shares. The yield is high, great for someone who plans to use it as income. The payout won't grow much, probably only keeping up with inflation, and doesn't leave a lot of room for investment in growth, share buybacks, or acquisitions without taking on debt. This profile is typically more suitable to a retired investor who prioritizes a high yield and a sustained payment over dividend increases or investment in the business.
The company's vaccine for COVID-19 will provide tailwinds for this year, making the payout manageable. Beyond 2021, Pfizer will need to prove it can earn enough in profits to keep the business growing while sustaining the 4.23% yield. If it doesn't, even a slowly increasing dividend will overtake the earnings used to pay it, and trigger a cut in the future. For now, it looks like management is doing what it can to pivot toward innovation without sacrificing the yield, making the stock an enticing investment for those interested in steady payouts.