According to Google Trends, which measures worldwide search trends, the term "dividend stocks" has roughly doubled in volume since the onset of the financial crisis in late 2008.
It's easy to see why given paltry yields on savings and high-quality bonds. Though dividend-paying stocks have a much different risk profile than CDs or Treasuries, a well-diversified portfolio of quality dividend stocks can help boost your current income and provide income growth potential through dividend increases.
Not just any dividend-paying stocks will do, however, and it's important to take a holistic approach to evaluating these opportunities. That's one reason that I created the Dividend Report Card last year, which looks at metrics like dividend history, payout ratios, and interest coverage to determine the sustainability and growth potential of a company's dividend.
Today, I'd like to take a bird's-eye view of dividend health at the sector level and take a gander at pharmaceuticals.
Just about every major pharmaceutical company has underperformed the S&P 500 over the past two years largely because of concerns regarding U.S. health care reform, austerity measures in Europe, patent expirations, and generic competition.
Still, the industry has a lot going for it, including demographic tailwinds and generally unhealthy lifestyle choices in many developed markets, as well as increasing demand in emerging economies. Large pharmaceutical companies also have a vast amount of intellectual property, patents, and scale that provide them with competitive advantages and barriers to entry.
A closer look
The most important factor when considering the health of a company's dividend is the free cash flow payout ratio. In other words, you want to make sure a company has enough extra cash left over after reinvesting in the business to fund the dividend.
That said, let's take a look at the free cash flow payout ratios of some of the sector's top-yielding shares.
Free Cash Flow Payout Ratio
|Roche Holdings (RHHBY.PK)||5.07%||61%|
Johnson & Johnson
Data provided by Capital IQ, as of March 30, 2011.
FCF = Net income Depreciation-Capital Expenditures-Change in Net working capital.
Foolish bottom line
The results of this quick screen are promising, but it's worth noting that this free cash flow calculation does not include cash acquisitions, an activity in which large pharmaceutical companies frequently partake. Before investing in any of these companies, it's important to take that into consideration.
Nevertheless, it appears that these pharmaceutical stocks generate an adequate amount of free cash flow to fund their well above-average dividend yields.
Looking for more dividend ideas? Click here for our free, five-page report "13 High Yielding Stocks to Buy Today."
Todd Wenning is the advisor of Motley Fool U.K. Dividend Edge and owns shares of GlaxoSmithKline and AstraZeneca. You can follow him on Twitter. Glaxo and Novartis are Motley Fool Global Gains recommendations. Pfizer is an Inside Value pick. Johnson & Johnson is an Income Investor and Inside Value selection. Motley Fool Options has recommended a diagonal call strategy on Johnson & Johnson. The Fool owns shares of Johnson & Johnson, Abbott Laboratories, and GlaxoSmithKline and has a disclosure policy.