In some ways, Merck (NYSE:MRK) is the most generous dividend payer on the Dow Jones Industrial Average (DJINDICES:^DJI). That's obviously great for Merck investors -- unless the pharma giant is going too far, of course.
Is Merck simply serving shareholders to the best of its ability, or is this generous dividend unsustainable in the long run? Let's see.
Today, Merck is looking back at $1.74 of trailing dividends per share over the past year. At current run rates, the payouts should be about $1.76 over the next year. That's a silver star to Merck for raising its payout, which is always good news for income investors.
Merck has generally been good at this kind of thing, though the company took a long break between 2005 and 2011 (no gold star for you!). Who wouldn't, with cash flows undergoing such a massive roller-coaster ride in that period? The mid-2000s were kind of rough for Merck:
On the downside, Merck is looking back at just $1.74 of earnings per diluted share in the past year. That's in line with its dividend payout, setting the payout ratio at an elegant yet scary 100%.
It's the Dow's highest payout ratio by a long shot, and the index's only dividend budget that completely exhausts the company's reported earnings.
Whoa! What's going on?
So far, so frightening. No company can afford to spend its entire earnings on dividend checks, right? There are other costs to consider, and this policy will surely eat up Merck's cash reserves in the long run.
But those were Merck's generally accepted accounting principles earnings. It's an accounting artifact that stems from tax-related calculations, and it's actually a good idea to keep this number as low as possible. The tax man is never a popular sight, and the less money he takes out of your operating income, the better.
Non-GAAP earnings tend to back out some of the accounting acrobatics companies do to get away from high taxes, and often look a lot stronger as a result. In Merck's case, trailing non-GAAP earnings currently add up to $3.54 per share.
Set against that backdrop, Merck's non-GAAP payout ratio drops to just 49% -- a perfectly reasonable and sustainable figure. It's still a bit high in context of the Dow, where the median ratio stands at 39%, but it's not outrageous at all.
Adjusted earnings can sometimes reflect a truer picture of a company's profitability -- but they're also prone to chicanery. High earnings impress investors and often boost executive bonuses. And since these figures aren't truly reported to the IRS or the SEC, there's all kinds of room for manipulation.
That's why free cash flow often gives you the best measure of real profits. We're back to strictly defined figures with accountability to regulatory bodies, and this time we're looking at the actual cash that moved in and out of the company in the reported period. At this point, it's really hard to hide unwanted expenses or inflate your profits. And on this basis, Merck comes through with flying colors:
Merck actually pays a smaller portion of its free cash flow as dividends than your average Dow stock. The median Dow ratio stands at 62%.
The Foolish takeaway
As you can see, Merck's seemingly unsustainable dividend payouts are actually just a mirage. It's an accounting artifact, created by tax-effective accounting practices. When you refocus on the non-GAAP numbers that Merck itself prefers to talk about, or even the underlying cash flow, the company actually has plenty of room for further dividend increases.
So Merck isn't perfect, given its fairly recent return to regular dividend boosts. But the payout policy is also not destined for an inevitable collapse, as the GAAP payout ratio might have you believe. Don't let Merck's sky-high payout ratio scare you away from an otherwise attractive income stock and its generous 3.1% yield.
Anders Bylund has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.