The pharmaceutical industry, or pharma industry, is one of the fastest-growing economic sectors with predicted worldwide sales of more than $1.3 trillion in 2018. Approximately 44.5% of sales each year come from North America, with U.S. sales predicted to be more than $370 billion in 2016. There is significant overlap between the biotechnology sector and pharma.

Pharma is a dynamic industry with rapid growth and the potential for high profits. Top-selling drugs have annual sales exceeding $1 billion. However, a new drug requires millions of dollars invested in research and development (R&D) and testing before it can be brought to market. The majority of new projects never receive approval from the Food & Drug Administration (FDA), resulting in large amounts of capital burned just to get one profitable product.

Individual pharma stock investors face a difficult task in analysis due to the high level of technical expertise required to adequately evaluate the viability of potential new products, as well as the continued prospects for existing FDA-approved drugs. The most stable stocks are those of large- and mega-cap companies with multiple products and large R&D budgets. However, the greatest returns come from smaller companies that achieve scientific breakthroughs.

Porter’s Five Forces Analysis

One model for examining an industry and a company's strategic position within its industry is Porter's Five Forces analysis. The analysis looks at five competitive forces that influence an industry: threat of new entrants, power of suppliers, power of buyers, availability of substitutes, and competitive rivalry in the industry. How these five forces interact provides a good picture of the sector's dynamics and whether an individual company is properly positioned for survival in the sector.

Threat of New Entrants

The big payoffs available in the pharmaceutical industry lead to a steady flow of new companies being created. A team of researchers with a hot idea or newly granted patents can find venture capital funds eager to provide millions of dollars in startup funding. These smaller companies pose no serious threat to big pharma. In fact, one of a startup investor's main exit strategies is to sell out to a big pharma firm when new products are through the initial development phase.

Power of Suppliers

Suppliers have very little power in the pharmaceutical industry. The raw materials for manufacturing drugs are commodity products in the chemical industry, which are available from numerous sources. Most of the equipment used in manufacturing and research is available from multiple manufacturers. Suppliers usually offer multiple products to the manufacturer, which moderates pricing on rarer materials and unique equipment.

Power of Buyers

Pharma is unique among industries because the medical patient has an absolute lack of power regarding pricing. The prescriber of the drugs, the physician, ethically is not allowed to profit from the sale of drugs. The entity that pays for the drugs, the insurance company, only has a say in how much it will pay to the distributor of the drugs, meaning it has little power with the drug manufacturers. The insurer can refuse to pay for treatments it believes are overpriced.

The only entities with any negotiating power are the pharmacies and medical institutions that fulfill the medical patients’ prescriptions. Even these entities have little power over newer drugs under patent or drugs with only one manufacturer. Pharmacies focus on their profit margins and have little incentive to provide patients with the lowest possible pricing.

Availability of Substitutes

The effect of substitutes is dependent on the individual drug. A new FDA-approved blockbuster drug that has patent protection, treats a major health condition and is first to market in its category has a license to print billions of dollars. The development of a new drug that cures a major disease could be worth tens of billions of dollars per year. However, the 30th drug to treat a common condition could take years to recoup the R&D costs.

Once a drug loses its patents, generic drug manufacturers start selling copycat versions at substantially lower prices. A drug that netted $100 million a year in profit could become one that earns only $1 million a year in profit overnight. Additionally, there is a major international problem with counterfeit drugs. The best of these counterfeits duplicates a real drug's formula and sells it at a lower price, which hurts corporate profits. The worst counterfeits are made with low-grade materials and can destroy the reputations of the legitimate products.

Competitive Rivalry

With more than $1 trillion in global sales, pharmaceutical business can be cutthroat. The huge importance of intellectual property results in strong competition for high-level workers and leading researchers. Even strong nondisclosure and non-compete clauses cannot prevent the leaking of competitive information.

Any potential new drug has its public information analyzed for the possibility of creating a similar drug to market as a substitute. The industry exhibits a pattern of firms merging and larger firms buying smaller firms that have promising research or new drugs.