What are franking credits?
Companies have earnings, and from those earnings, they retain some of it to grow the business so that future earnings increase, and pay out the rest to shareholders as dividends.
When a company makes a profit, they pay tax on that profit before the dividends are paid out to the shareholders. Then when the shareholders get their money, they have to pay income tax on it. So, they are getting taxed twice on the same income. To address this, the Australian government introduced franking credits, which are credits for tax already paid so that shareholders are not taxed twice on the same earnings.
Let’s say a company earns their profit and pays 30% tax, and then distributes $70 to shareholders for each share. What has really happened is that the company earned $100, and the shareholder has already paid $30 in tax, so even though the shareholder received $70, on their tax return they would declare it as $100 income and $30 tax already paid. If their marginal tax rate is over 30%, they will need to pay only the difference above the 30% already paid. If their marginal tax rate is below 30%, they will get a refund for excess tax already paid above their marginal rate.
How does this impact our investment decisions?
When you invest in non-Australian companies, you don’t get franking credits, so there is an incentive to buying Australian shares over non-Australian shares.
We can calculate roughly how much benefit franking credits provide.
In Australia and the US, historical total returns (combined returns from both dividends and growth) have been around 6% over inflation. In our current 2% inflation environment, we can estimate the average nominal returns at 8%. Australian shares pay out around 4% of that as dividends, so the “grossed up” dividend (the dividend plus the franking credits) is 100/70 x 4% = 5.7%, so there is a 1.7% benefit from franking credits.
If 75% of your Australian dividends are franked, such as in the ASX200, this becomes 100/70 x 3% = 4.3%, so there is a benefit of 1.3% from franking credits.
But do we really get this return?
On the date a dividend is declared payable by the company (called the ex-dividend date), the market recognises that the amount paid out has reduced the company’s total value by that amount paid out. As a result, the share price drops by the amount of the dividend, and consequently, dividends are not free money.
Some people argue that this isn’t true because the share price doesn’t fall by exactly the amount of the dividend paid out. Sometimes it’s more, and sometimes less. This can be explained by the fact that during the rest of the time, when dividends are not paid out, the share price moves up and down and all over the place. The market is reacting to new information about the company, sector, or market it is in. For example, a company might release sales results for the past quarter, and the price moves up in anticipation of future earnings. When a share goes ex-dividend, these forces are still in play, and therefore the share price doesn’t drop by exactly the price of the dividend. That the share price drop isn’t precisely the amount of dividend paid out doesn’t refute the fact that the share price adjusts based on the dividend paid out.
What has this got to do with franking?
Well, the same thing happens with franking credits. Take a look at how much the share price drops on shares with franked dividends when they go ex-dividend, and you’ll notice that it is quite a lot more than the dividend amount.
This is because franking credits are largely priced-in. Most of the benefit you get from franking credits is lost by way of the share price falling. Only you don’t realise it because the way it is lost is not obvious. As a result, you’re not getting the full return from them that you think you are.
When franking credits were first introduced and before people understood it, they provided the full return, but once it became widely understood, the market priced-in a big part of the added return, and it has been arbitraged away.
Vanguard’s research has shown as much.
Investors place a higher value on dividends paid by companies that have imputation credits attached. This is evident in the domestic market place. Usually after a company’s dividend is paid, the share price drops further than the cash payment of the dividend due to the added value placed on the imputation credit. Our analysis of the dividend payments from one of the largest companies by market cap in the Australian market, National Australia Bank (ASX Code: NAB), found that out of 64 dividend payments since 1987, when dividend imputation was introduced, the ex-dividend price fell by more than the cash dividend 69% of the time. Of the declines, nearly half were of an amount greater than the grossed-up dividend, the other half being an amount slightly less than the grossed-up amount. Similar results were obtained from analysis of other major Australian companies paying dividends that have an imputation component.
There appears still to be a higher return than without franking credits, but it’s far less than what is commonly quoted as the franking amount.
It is hard to pin down exactly how much because, as described above, all the other market forces are in play, so we can’t get an exact figure, but from the links below, it appears to be around 40-80% priced-in.
So how much are franking credits really worth?
Let’s do the maths.
With franking credits looking to be around 40-80% priced in, even though we can’t get an exact figure because of the way the market keeps moving all day every day, let’s go with the middle of the range to put a number to the benefit, so 60%.
With Australian shares paying around 4% of the return as dividends and with 3% being fully franked dividends, the “grossed up” dividend (the dividend plus the franking credits) is 100/70 x 3% = 4.3%, resulting in a benefit of 1.3% from franking credits.
But we need to remove what is priced in, which leaves a benefit of 1.3 x 0.4 = 0.5%.
0.5% is nothing to scoff at.
But that higher return is not free. You’re paying for that higher return by way of higher risk.
The Australian stock market is very poorly diversified, with half of the entire value in mining and finance. Much of the latter is by way of the government constricting land supply to drive up land value to collect more tax. Do you really want your financial security based on this continuing rather than diversifying into the many other sectors available in a global basket of stocks? On top of this, by investing in the Australian market, you now have your property, income, and all your assets in one market. If there is a downturn in the economy, everything will go down together. This is what I mean when I say that franking credits are not free — you’re paying for it with higher risk.
Let’s say you went with 50/50 Australian/International equities to reduce your concentration risk from 100% Australian stocks. You’re then increasing your expected return by 0.25% instead of 0.5%
Now let’s say you thought (like I do) that 50% in the concentrated Australian stock market is still way too much, and you made it 25% of your equities. Your franking benefit results in an increased expected return of 0.125%
Diversifying a full 25% more equities (from 50% Australian equities down to 25% equities) costs you a mere 12.5 basis points compared to having half of your equities in the Australian market, and your diversification has gone up enormously.
This begs the question, what impact would this have as a reason to invest in Australian shares over their natural market cap proportion?
Previously we would choose Australian shares to help mitigate currency risk, but now we have a global AUD-hedged fund to reduce currency risk without the added concentration risk of over-weighting Australian shares.
Once that has been addressed, we can still say that Australian shares give a higher return due to franking credits, so that means overweighting Australian shares still offers a reward for the higher concentration risk, but with quite a bit less benefit for the higher risk, it might be worth re-examining how much value over-weighting Australian shares really provides and how much we want to overweight them.
The Financial Implications of the Dividend Imputation System (cached copy)
Dividend imputation – its rationale and its impact on superannuation outcomes (cached copy)
Estimating The Market Value Of Franking Credits (cached copy)