After the recent fall in stock price of many drugmakers, their dividends are looking mighty attractive. Dividends, after all, contribute significantly to historical overall returns of stocks, and when the stock price goes down, the contribution from the dividend increases.


Dividend Yield

Pfizer (NYSE: PFE)


Merck (NYSE: MRK)


Johnson & Johnson (NYSE: JNJ)


Eli Lilly (NYSE: LLY)


Bristol-Myers Squibb (NYSE: BMY)


Source: Capital IQ, a division of Standard & Poor's.

The problem with dividend yields
On the surface, those dividends look tempting when you can only get a few percentage points on a CD if you're lucky. It's important to keep in mind though that the dividends aren't guaranteed; companies can and will cut or suspend their dividends to conserve their cash for other uses. More on that later.

Also unlike an investment in a CD, the share price isn't guaranteed. The dividends provide a little support for the stock; as the price begins to fall, the yield increases, and the stock becomes a more tempting investment. But that's no guarantee that people will buy the stock. Sound fundamentals are still relevant even when the yields approach double digits.

Delving deeper
It's important to look at whether the drugmaker can continue to pay out its dividend. High yields obviously aren't sustainable if the company is paying them from its treasury; they need to be paid from cash generated from operations.

But that cash also has to pay for capital expenditures -- manufacturing plants and the like. After subtracting that out, we get the free cash flow -- what's left to pay the dividends and grow externally through acquisitions and licensing deals.


Dividends Paid TTM
(in millions)

Free Cash Flow TTM
(in millions)

Payout Ratio









Johnson & Johnson




Eli Lilly




Bristol-Myers Squibb




Source: Capital IQ, a division of Standard & Poor's. TTM=training twelve months.

None of the drugmakers looks particularly in jeopardy of not being able to pay their dividend. Pfizer and Merck haven't left much cash to grow externally, but they haven't had much of a problem returning cash to their shareholders either.

But it's the future that matters
The problem with the payout ratio is that it's backwards-looking. What investors should care about is whether the drugmaker will be able to pay future dividends. In many industries, past performance is indicative of future returns, but for drugmakers, the past successes are only indicative of future generic competition.

Of the five drugmakers profiled above, Eli Lilly and Pfizer face the steepest patent cliffs; Eli Lilly has multiple top drugs going off patent over the next couple of years and Pfizer will lose Lipitor, the number one selling drug in the world, next year. The loss of revenue is sure to trickle down into less free cash available to pay dividends.

Bristol-Myers also faces a steep revenue decline with the inevitable loss of Plavix, but it also has a decent pipeline and a hoard of cash to deaden the blow.

Merck's revenue growth has stalled of late, but it has a decent pipeline thanks to the acquisition of Schering-Plough. If the pipeline can come through, maybe we might even see a dividend increase, something that hasn't happened since 2004.

As long as you're holding for the long term and willing to ride out its quality control issues, Johnson & Johnson is a solid choice considering the company's history.

Getting paid to wait
One of the reasons that each of these drugmakers has such a high dividend yield is that earnings growth -- and therefore stock price appreciation -- is likely to be stalled over the next few years. If returns aren't going to come from capital appreciation, investors need to be paid to wait.

If you're looking for stock price appreciation, choosing a high-growth drugmaker such as Gilead Sciences (Nasdaq: GILD) or Celgene (Nasdaq: CELG) that don't offer dividends might be a better option.

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Pfizer is a Motley Fool Inside Value recommendation. Johnson & Johnson is a Motley Fool Income Investor selection. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool has a disclosure policy.