There are various signs investors look at to see if a stock is fundamentally healthy. One of the bigger signs to see this is a dividend hike. I would argue that large dividend increases reflect confidence from a stock's management and board of directors.

That's why it was notable when Viatris (VTRS 0.75%) announced a 9.1% increase in its quarterly dividend from $0.11 to $0.12 per share earlier this month. But can the stock afford the dividend hike? And is it a buy? Let's take a look at Viatris' fundamentals and valuation to answer these questions.

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Throwing off tons of free cash flow

What led Viatris' Board of Directors to hand out a huge raise to shareholders? Part of the answer lies within the company's payout ratios.

Viatris' average analyst estimate for non-GAAP earnings per share (EPS) is $3.71 for 2021. Against the $0.33 in dividends per share that were paid out for in 2021 (due to only three $0.11 per share dividend payments during the year), this is a payout ratio of just 8.9%.

Even considering that $0.48 in dividends per share will be paid in 2022 at the current dividend rate, the average analyst estimate is $3.74 for the year. This comes out to a 12.8% payout ratio, which should translate into a growing dividend in the years ahead.

Non-GAAP EPS is one thing, but free cash flow is arguably the more important payout ratio. That's because a company either has the cash to support its dividend or it doesn't. It's much harder to fake cash flow than it is to manipulate non-GAAP EPS.

According to the company's January earnings press release, Viatris returned $266 million in dividends to its shareholders by way of its two dividend payments to date at the time of the earnings press release. Adding in the third dividend payment of the year and assuming a flat share count, Viatris will have paid about $400 million in dividends in 2021. Against the $2.5 billion in midpoint free cash flow that Viatris is forecasting for 2021, this equates to a 16% payout ratio. This again leaves plenty of room for future dividend growth.

Assuming that the quarterly dividend is held at $0.12 per share for all of 2022 and an unchanged share count, Viatris will pay roughly $580 million in dividends to shareholders this year. Even factoring in no growth from the 2021 midpoint free cash flow figure of $2.5 billion, this is a manageable 23.2% payout ratio.

Deleveraging efforts are progressing

The second piece of the puzzle that I believe prompted the payout increase from Viatris was the continued progress that the company has made in repaying its debt.

Through the first three quarters of 2021, Viatris repaid approximately $1.9 billion of debt. That's thanks to the company's significant free cash flow noted above. At the rate Viatris is going, the company is easily on track to meet its cumulative debt repayment target of $6.5 billion by the end of next year. 

While Viatris still had nearly $21.8 billion in long-term debt in the third quarter, the company is producing the earnings before interest, taxes, depreciation, and amortization (EBITDA) necessary to shoulder the burden of its debt load. Pairing Viatris' debt reduction with a slight uptick in EBITDA is why analysts expect the debt to EBITDA ratio will drop significantly, from 3.3 in 2021 to 2.4 by the end of next year.

Viatris' progress in reducing its debt thus far and its commitment to further debt repayment should allow the stock to maintain its investment-grade credit rating. Thus, it's not difficult to see why the company's firm financial footing gave it the conviction to up its payout.

An undervalued income stock

Viatris looks to boast a safe dividend and decent balance sheet. So, should investors buy the stock?

Well, the stock is trading at a forward price-to-earnings (P/E) ratio of 4. Even with minimal earnings growth expected in the years ahead, Viatris' P/E ratio is simply too low for a company of its quality. While investors wait for Viatris to be recognized by the market, they can sit back and collect the market-beating 3.3% dividend yield. Income investors looking for a deep value stock would do well to consider buying Viatris for their portfolio.