Dividend yield numbers deserve scrutiny

If two companies each pay out $2 annually in dividends, they may seem equally attractive on that basis. But you really need more information. One might be selling for $20 per share, and the other for $100. If so, you’ll be getting a much bigger dividend bang for your buck with the former firm. Its dividend yield is much higher.

A company’s “dividend yield” expresses the relationship between its stock price and the amount of its annual dividend. Consider financial giant Citigroup, recently trading around $46 per share and paying a dividend of 44 cents per quarter ($1.76 per year). Dividing $1.76 by $46 gives you 0.038. Multiply that by 100, and you have a dividend yield of 3.8 percent. If you pay $46 for a share of Citigroup today, you’ll earn 3.8 percent per year on your investment, just from dividends alone.

Better still, dividends of healthy companies tend to increase over time, delivering additional value. If in 20 years Citigroup’s dividend is $5, that would represent an 11 percent dividend in relation to those shares you bought for $46. (You paid $46; you receive $5 per year.) You’d be earning 11 percent each year, just from dividends. There would likely be some stock price appreciation on top of that, too.

Companies rarely decrease or eliminate their dividends, as that would make investors unhappy. It does happen, though. Ford reduced its dividend in 2002, while auto part supplier Visteon recently eliminated its dividend entirely.

Dividend yields usually fluctuate daily, since they’re tied to the stock prices. As a stock price rises, the yield falls, and vice versa. If Citigroup’s shares, for example, suddenly doubled in price to $92, the yield would be halved, to 1.9 percent ($1.76 divided by $92 is 0.019).

You’ll find some hefty yields among companies whose stock prices have tumbled — but be careful. Some such firms never recover from their troubles.

Not all companies pay dividends. Some need to plow all their extra cash back into operations and growth. Microsoft began paying a dividend a few years ago, while eBay and Dell pay no dividend at all.

Ask the Fool

Q: For tax purposes, can I deduct the trading commissions I pay to my brokerage from my net capital gain? — U.C., Nevada, Mo.

A: Yes, you can — and you should. The expenses incurred in buying or selling a capital asset (stock, in this example) are capital costs, and they need to be factored in to your cost basis and proceeds.

Imagine that you buy $3,000 of stock and pay $30 in commission and other charges. Your actual cost is $3,030. You sell the stock later, when it’s worth $4,000, paying another $30 to the brokerage. Your “net” sales price (generally, the amount reported to you by your broker at year-end on your Form 1099B) would be $3,970 ($4,000 less $30). On your tax return, you would report a gain of $940 ($3,970 less $3,030 equals $940.) By ignoring the cost of commissions, your gain would be $1,000, and your taxes would be higher.

Q: What’s a “market maker”? — S.N., Hickory, N.C.

A: You might think that when you buy stock, you’re getting those shares directly from a shareholder who’s selling, but that isn’t quite the case. Stocks are generally bought and sold through market makers. Maintaining a fluid market, they earn their keep by pocketing some or all of the spread between the purchase and sale price. Market makers typically keep some shares in inventory, too. That way, if someone wants to buy shares and no one wants to sell at that time, the market maker can sell from inventory.

My smartest investment

I bought shares of eBay about a year after they were first offered, and I’ve stuck with the company to this day. It’s done nicely for us. But I wasn’t smart or savvy. I just liked eBay and enjoyed using it. — Jim, Morris County, N.J.

The Fool Responds: Well, being familiar with a company and its products is a valuable first step when investing in it. But it’s not enough of a reason to buy shares. You might love your Chevy Impala, but that doesn’t mean that General Motors is the best place for your money. You need to consider, among other things, what a company’s big challenges are. Will GM gain market share from Japan and elsewhere, and meet its pension obligations? Will eBay become a top dog of online auctions and commerce in new markets such as China? Shares of eBay have advanced more than 4,000 percent since they debuted in 1998. (Of course, many investors weren’t able to snap up shares on the first day, and the price rose quickly. Still, even if you bought a year later, you’ve probably roughly doubled your money.)