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Source: Flickr user TaxRebate.org.uk

Dividends are the lifeblood of any long-term-focused retirement portfolio. But, unfortunately, not all dividends are created equally. Some aren't worth the paper they're printed on because the dividend is so small, while others simply lack sustainability, either in the payout or in the underlying business model. That's why, when buying a dividend stock, it's important to conduct a dividend payout ratio analysis.

What do I mean when I say "dividend payout ratio analysis?" Simply put, we need to establish if the dividend being paid out by a company is sustainable, because if it is, and it has the chance to grow, then the stock is liable to attract long-term buyers and potentially be less volatile. It also helps establish the financial stability of a company.

A dividend payout ratio (the percentage of earnings per share paid out as a dividend to investors) that's too high, for instance, could signal trouble, but that's not always the case. Today, we're going to take a look at a big pharmaceutical company that's a dividend income portfolio staple because of its current 3%-plus yield, Merck (NYSE:MRK), and establish whether or not its payout ratio is stable, or if there's really danger looking in this dividend.

Dividend payout ratio analysis on Merck
According to data provided by S&P CapitalIQ, Merck's current dividend payout ratio is 92%. With a quarterly payout of $0.44 and a noted trailing EPS over the past four quarters of $1.90, Merck would appear to not be leaving itself much room for error, or to boost its dividend. However, we need to dig a bit deeper to get the full picture.

MRK Payout Ratio (TTM) Chart

MRK Payout Ratio (TTM) data by YCharts

While Wall Street and investors tend to follow a company's non-GAAP earnings, or its profit per share when excluding nongenerally accepted accounting principles, Merck's current payout ratio is being measured against its GAAP earnings of $1.90 over the trailing four quarters.

What's the difference between GAAP and non-GAAP earnings? Think of non-GAAP EPS as a company stripping out one-time and/or nonrecurring expenses like asset write-downs, restructuring costs, merger and acquisitions costs, and so on. GAAP, on the other hand, includes these costs and acts as a uniform measure of profit across all business sector. In other words, Merck has earned $1.90 per share inclusive of its M&A costs, restructuring costs, and other extraordinary expenses over the trailing 12 months. However, when these costs, which are only expected to last a few quarters, are removed from the equation, Merck actually earned $3.53 per share over the trailing 12-month period.

Merck Hq

Source: Merck & Co.

This is a pretty sizable GAAP vs. non-GAAP discrepancy, but it's also not uncommon for a company the size of Merck which has been restructuring its business to reduce costs in the wake of patent exclusivity losses on blockbuster drugs like asthma medication Singulair and brain cancer drug Temodar. In addition, Merck also agreed to purchase Idenix Pharmaceuticals for a whopping $3.85 billion in order to get a hold of its hepatitis C pipeline. In short, Merck's had quite a few one-time expense recently, and they've translated into some very wide GAAP vs. non-GAAP earnings spreads.

What's the real payout ratio for Merck? Truthfully it probably lies somewhere in between the 92% payout ratio that the GAAP earnings would imply and the healthy 50% payout ratio that the non-GAAP earnings imply. Essentially, we understand that these costs Merck is dealing with aren't long-term expenses that will adversely affect its business beyond a few quarters. However, we also can't completely look the other way because they do have the potential to adversely impact profits.

Is Merck's dividend sustainable?
Now let's answer perhaps the most important question of all for income investors: Is Merck's dividend sustainable?

Though I can't overlook some near-term costs for Merck which are dragging down its GAAP profits, I also would opine that its restructuring and merger and acquisition costs are near an end. In other words, Merck's true payout ratio, which as I said probably lies somewhere between its GAAP and non-GAAP EPS, appears to be sustainable. That doesn't mean investors should expect a big dividend increase anytime soon, as Merck's dividend has grown by just 16% over the past decade to $0.44 per quarter from $0.38 per quarter, but it does mean that its current payout is relatively safe. 

Keytruda

Source: Merck & Co.

Another factor that should ensure Merck's dividend at least survives at its current level is the recent Food and Drug Administration approval of anti-PD-1 inhibitor Keytruda. Developed as a treatment for advanced-stage melanoma, Keytruda enhances the body's immune system to help recognize and fight cancer more effectively. In clinical studies that led to its approval, 24% of patients taking the drug had their tumors shrink, with the duration of response typically lasting between 1.4 months and 8.5 months. That may not sound like a lot, but considering it was being tested as a last-line therapy this response rate and duration of response is a big step in the right direction.

Even more so, Keytruda could have incredibly positive implications in a number of other indications, such as nonsmall cell lung cancer (NSCLC) where it's currently being studied in midstage trials. Advancements in NSCLC have been few and far between over the past couple of decades, with five-year survival rates improving from just 12% in 1975-1977 to 17% in 2002-2008 according to the American Cancer Society. This patient group could use a breakthrough drug, and Keytruda may be the answer.

So, to summarize, yes, Merck's dividend is safe; no, it's payout is unlikely to rise much if at all over the next few years as it grapples with patent expirations; and watch Keytruda as it could be the single-handed reason why and if Merck raises its payout in the future.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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