To The Moon

$Merck(MRK)$

Over the past five days, the market has been quite mixed. However, one key observation remains: many companies are currently trading at significant valuations, especially when compared to their own five-year averages. Today, we want to highlight a company that appears to be exceptionally well-valued—Merck & Co.

Based on its forward valuation of 8.42 and a strong starting yield of nearly 4%, Merck presents a compelling opportunity. The key question is whether this stock is a must-buy, particularly for dividend-focused investors. Given that Merck’s stock has declined around 35% over the past year and is trading near its 52-week low, it's worth evaluating whether this presents a golden buying opportunity.

Both Wall Street and Seeking Alpha have issued a resounding “buy” rating for Merck, a rarity for stocks we discuss on this channel. The company’s valuation earns an A+, as do its growth and profitability metrics, making it a strong contender for serious consideration.

Looking at Merck’s performance over the past decade, the stock has underperformed the S&P 500, gaining only 42%. However, with a current dividend yield of 3.9%, it may still be an attractive option in today’s overinflated market.

Now, let’s examine Merck’s recent earnings report, which was released just a few weeks ago. Despite a solid performance, the company’s stock took a hit due to the pause in vaccine shipments to China, impacting its 2025 outlook. The revised guidance fell short of Wall Street’s expectations, raising concerns about future revenue.

Earnings Breakdown:

Earnings per Share (EPS): Reported at $1.72, beating the market estimate of $1.62. Revenue: Came in at $15.62 billion, exceeding the forecast of $15.49 billion. Net Income: A significant improvement at $3.74 billion for the quarter, compared to a $1.23 billion loss in the same period last year.

Despite these positive results, the key issue affecting Merck’s stock is its lowered revenue forecast for 2025. The company now expects sales between $64 billion and $65.6 billion—well below Wall Street’s estimate of $67.3 billion. This shortfall is primarily due to the halt in shipments of its HPV vaccine to China, a market that represents a significant portion of the product’s international revenue.

Key Risks:

The suspension of vaccine shipments is expected to last at least until mid-2025, though it could be extended further, posing additional downside risks. Investors remain uncertain about the long-term impact on Merck’s revenue and profitability.

Potential Upside:

Merck has a strong track record of meeting or exceeding earnings expectations, with a 100% beat or in-line performance over the past four quarters. For 2025, analysts expect three out of four quarters to be positive, with strong double-digit EPS growth anticipated in the latter half of the year.

Currently, Merck’s full-year EPS is projected to be just under $9, giving it a forward valuation of 9.3. This represents a 51% discount compared to the broader sector, which is trading at a multiple of 19. While a discount doesn't always mean a stock is a strong buy, Merck’s valuation appears particularly attractive when compared to its own five-year average of 18.2—a nearly 50% discount.

Growth Outlook:

Revenue Growth: 6.9% year-over-year, close to the sector median but slightly below its five-year average of 11.2%. Projected Revenue Growth (Next 12 Months): 5.2%, slightly under both the sector median and its own historical average of 6.11%. Earnings per Share Growth (Next 3-5 Years): Expected to outperform the sector at 16% vs. 10.6%, making it a strong long-term prospect.

Merck & Co. is currently trading at a significant discount compared to the sector, yet its profitability remains highly impressive. It boasts an A+ rating in this area, with a gross margin of 81%, well above the sector average of 58% and its own five-year average of 73%. Additionally, its bottom-line profitability stands at 27%, significantly higher than the sector average.

One particularly notable improvement is its cash burn rate, which is now at -4%, a sharp contrast to its five-year average of -18%. This indicates that Merck is becoming increasingly efficient in managing its finances, particularly when compared to its own historical performance. In terms of cash from operations, the company generates over $18 billion, while the sector overall is burning through cash at -14 million. This also represents a significant improvement over Merck’s own five-year average of 14.84%.

Dividend Strength & Stability

Merck increased its dividend by 5.2% last November, slightly above the inflation rate. Seeking Alpha reaffirmed its "very safe" dividend score just yesterday, signaling that a dividend cut is highly unlikely.

Looking at its resilience during economic downturns, Merck maintained its dividend during the 2007–2009 recession—neither increasing nor cutting it. The company also performed better than the S&P 500 during that period, with a decline of -4% compared to the S&P’s -12%. Additionally, its total return nearly matched the S&P: 57% vs. 55%.

Over the past 20 years, Merck has consistently increased its dividend at a 4% annual rate, ensuring steady growth. More recently, it raised its dividend by 7% last November—well above inflation. The company has now increased its dividend for 13 consecutive years and has paid a dividend without reductions for 54 years.

Valuation & Undervaluation Signals

Looking at valuation metrics, Merck is currently trading at a substantial discount based on its forward P/E ratio. However, it’s important to assess this within a broader valuation model. The expected fair price model indicates a significant disparity between Merck’s current price and its fair value, further supporting the undervaluation thesis.

One additional metric supporting this is Dividend Yield Theory—which suggests a stock is undervalued when its current yield exceeds its five-year average. As of today, Merck’s dividend yield is at its highest level in the past five years, reinforcing the idea that the stock is significantly undervalued.

Free Cash Flow & Growth Trends

Free Cash Flow (FCF): A critical metric, FCF can be manipulated through earnings adjustments, so we look at FCF as a percentage of earnings. Ideally, we want this below 60%, and while Merck’s historical trend has been inconsistent, it is projected to decline to 35% over the next 12 months, potentially allowing for another attractive dividend increase this November. Free Cash Flow Per Share: Ideally, we want to see consistent increases over time. However, Merck’s FCF per share has shown some inconsistencies, though a significant increase is projected over the next 12 months.

Revenue Growth: While ideally, we prefer 3%–7% annual growth, Merck's revenue has shown some inconsistency on a year-over-year basis. However, 2024 was a strong year, posting 7% growth. Long-Term Revenue Growth: Over the past 10 years, Merck’s revenue has steadily grown. That said, investors should maintain realistic expectations based on the company’s industry dynamics.

Share Buybacks & Return on Invested Capital (ROIC)

Merck has historically returned capital to shareholders through share buybacks, but since 2020, these buybacks have completely halted. While this is not necessarily a red flag, it is worth noting, as buybacks can be an added bonus on top of dividends.

One of the most important efficiency metrics, ROIC (Return on Invested Capital), provides insight into how effectively management is allocating capital. Ideally, we want 10% or higher—Merck currently sits at 28%, a very strong number that has been consistently improving over the past decade.

Profit Margins & Financial Health

Operating Margins: Increasing margins is a key indicator of operational efficiency. Merck’s operating margin has improved from 22% to 35%, reinforcing the notion that management is effectively running the company. Free Cash Flow Margins: Consistently well above 5%, showing strong cash generation capabilities. Debt Metrics (Net Debt/EBITDA): A key indicator of balance sheet strength, this metric measures how many years it would take for the company to pay off its debt using EBITDA.Current 12-month figure: 0.88Next 12-month projection: 0.77Conclusion: Merck has a very strong balance sheet, further reinforcing the safety of its dividend.

Industry Comparison & Long-Term Performance

To provide context, we compare Merck’s total return (including dividends reinvested) against other leading pharmaceutical companies like Novartis and AstraZeneca. Unfortunately, Merck has been the worst performer, delivering just 33% total return over the past year.

When expanded to a 5-year view, its performance remains weak, with just 24% total return—though many competitors have struggled similarly.

Over the past 10 years, Merck’s total return stands at 103%, effectively doubling an initial investment made a decade ago. However, this still underperforms the S&P 500, which is a key concern for investors selecting individual stocks.

Institutional & Insider Activity

Institutional ownership in Merck & Co. stands at 76%, with $14 billion in sales over the past year, covering all of 2024. Notably, there has been significant institutional buying, particularly in Q4, where institutions were purchasing more shares than they were selling—a strong bullish signal.

In terms of insider ownership, it remains low at 0.09%, with little buying or selling activity over the past year. While insider selling occurred recently (with one insider offloading 2,000+ shares), this is not typically viewed as a bearish indicator, as insiders sell for various personal and financial reasons. On the same day, a director purchased 2,833 shares, highlighting mixed insider sentiment. For transparency, all insider transactions are available for review if investors wish to incorporate them into their analysis.

Revenue & Profitability Trends

Merck’s top-line revenue has shown steady growth over the past decade, albeit with some inconsistency. However, what’s more critical is the bottom-line performance—and here, we observe a positive trend despite some fluctuations.

Net income has grown significantly from $4.4 billion in 2015 to $17.1 billion in 2024, indicating substantial long-term profitability. 2023 was a weak year in terms of net income, but overall, the trend remains upward. Due to these inconsistencies, applying a margin of safety when valuing the company is prudent.

Financial Health & Debt Analysis

A quick financial health check reveals some inconsistencies in cash levels, which is common for businesses of this scale.

Cash on hand has fluctuated from $13.4 billion in 2015 to just under $15 billion in the latest quarter. Total debt, however, has increased from $26 billion to $38 billion over the same period.

That said, Merck’s net debt-to-EBITDA ratio remains strong, meaning the company would not take long to pay off its debt if necessary. Additionally, the dividend remains very secure based on these metrics.

Another key positive is the company’s cash flow from operations, which has grown from $8 billion in 2014 to $18.3 billion today—although, again, there are some fluctuations.

Valuation & Intrinsic Price Calculation

Before diving into the valuation details, note that our latest free weekly article covers undervalued stocks and market trends. You can sign up to receive insights directly in your inbox every Monday, including 45 undervalued stocks for February and Wall Street’s top 32 picks in the S&P 500.

Now, onto Merck’s valuation. Our intrinsic price calculation yields an average valuation of $119 per share, based on three valuation models:

Multiples Valuation: Compares Merck’s P/E ratio to similar-sized companies in the pharmaceutical sector.Results in an intrinsic value of $124, signaling undervaluation.

Dividend Discount Model: Based on Merck’s consistent dividend growth at 5.84% over time.We took a more conservative growth estimate of 5.25%, still showing undervaluation.

Discounted Cash Flow (DCF) Model: Assumes 10% free cash flow growth, aligning with analyst projections.Includes a discount rate for present value calculations.Confirms another undervaluation signal.

The combined average valuation comes to $119 per share, reinforcing the view that Merck is undervalued.

Margin of Safety & Wall Street Sentiment

We always apply a 10% margin of safety when evaluating stocks, which is critical for risk management.

• A stock qualifies for a "buy" recommendation if it meets these three golden criteria:

  Wide moat (competitive advantage)Strong financial metricsPositive forward-looking data

• If all three are met, we consider buying up to $117 per share.

• If not, we wait for the stock price to approach its current trading value before making a move.

Currently, Merck has a near 30% margin of safety (MOS)—a strong signal for value investors.

Wall Street & Seeking Alpha analysts are also bullish, with an average price target of $116, representing 38% upside.

Conclusion

While Merck has underperformed the S&P 500 in the past year, five years, and even over a decade, its strong valuation, impressive profitability, and rock-solid dividend track record make it a compelling opportunity for value and dividend-focused investors. However, it’s crucial to weigh this against its historical underperformance and industry-specific risks before making an investment decision.

Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.

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