How valuable are franking credits?

Like many investors, Australians exhibit home bias. That is the tendency to prefer local shares over global shares. There are many reasons for this phenomenon including familiarity with local companies and increased comfort with the local political and legal environment.

In Australia there is an additional reason keeping local investors focused on ASX listed shares. Franking credits.

What is a franking credit?

Franking credits are used to prevent the double taxation of dividends. As a shareholder an investor is an owner of a business. The business pays taxes on income earned. When a portion of that income is passed along to a shareholder in the form of a dividend it is taxed again. Franking credits make up for this double taxation.

The franking credits can offset other taxes owed or are cash payments to shareholders if they exceed total taxes owed. Some investors in lower tax brackets will receive a refund from the ATO. Investors in higher tax brackets will receive an offset against taxes they are owned. In this way all Australian investors who own Australian shares benefit from franking credits.

Since franking credits put money in investors pockets they have value. In this article we are going to attempt to quantify that benefit.

The following formula can be used to calculate the value of a franking credit.

((dividend amount ÷ (1 – company tax rate)) – dividend amount) x franking percentage

For most listed Australian companies the tax rate is 30%. We can calculate the value of a franking credit for a company that pays a $1 dividend that is 100% franked using the formula:

(($1 ÷ (1 – .30)) – $1) x 100% = $0.43

We will come back to that calculation later. But first a look at the impact franking credits have had historically on returns. Franking credits added around 2% to ASX 200 returns which represented 22% of total returns in the period covered in the chart. That is meaningful.

The value of a franking credit

Historically it is easy to see how franking credits have benefited returns for Australians who invest in Australian shares. But investing is about the future.

I am going to attempt to answer the question of how much future franking are worth to investors. This comes in handy when investors are choosing between different investment options.

Valuing any investment is an educated guess. We don’t know what will happen in an unpredictable future. The same holds true of valuing a specific component of an investment like a franking credit. But ultimately, we aren’t looking for precision. We are looking for a rough estimate that can help inform an investor trying to navigate an uncertain world.

A good place to start is with the principles of valuing an asset. There are three things needed to value any asset:

The value of any asset is the cash flows generated in the future. That is true of a share, bond, real estate investment or a new project a company is considering.
We can’t just add up all the expected cash flows to arrive at a value. The timing matters as well. A dollar today is worth more than a dollar in the future. If someone offered to give you a $1,000 today or $1,000 in 5 years you would pick today. That means that we need to discount future cash flows.
Finally, we need to account for the uncertainty of future events. An informed estimate of the future is better than a wild guess. But anything can happen. Some assets have more predictable cash flows. Some have a wide range of potential outcomes. We need to provide a margin of safety to account for the lack of precision in our estimates based on the specific circumstances of the asset in question.

A franking credit is simply a cash flow that an Australian investor owning an Australian share is entitled to. For this exercise we are going to use two different shares that are exactly the same with the difference being that one is Australian and one is global.

This exercise would also be applicable to an Australian share and an Australian real estate investment trust (“REIT”) as REITs do not provide franking credits. It would be applicable to an ETF which owns Australian shares and an ETF that owns global shares.

Our hypothetical share has a dividend yield of 2.5% and paid a dividend of $1.00 last year. In the last 5 years the Australian share’s dividend was 100% franked. The franking credit is therefore worth $0.43 which we calculated using the formula provide at the beginning of the article.

This gives us the foundation for estimating the value of the franking credit but I will provide the other information we need as we go through the exercise.

Using the Morningstar research methodology on franking credits

Our analysts create a discounted cash flow model to estimate the fair value of a share. This is simply a way to apply the valuation principles I outlined earlier into a model.

The first thing our analysts do is project cash flows into the future. This is a very difficult exercise. It becomes more difficult as the analyst looks further into the future. That is why our analysts stop at 5 years for most companies and 10 years for some. I am going to use five years for this exercise.

That doesn’t mean a company will stop generating cash flows after the 5-year period. In this case our analysts will apply an assumed growth rate in cash flows after the initial period.

We can do this for our franking credits. We are going to assume the company is going to grow dividends at an annual rate of 5% for the next five years and 3% thereafter. We will assume the 100% franking is maintained in the future.

The future cash flows need to be discounted. That goes back to the principle of a dollar today being worth more than a dollar in the future. Our analysts use the weighted average cost of capital (“WACC”) to do this. In this case we will assume a 10% WACC.

First we can calculate the value over the next 5 years. The value of the franking credit has grown 5% a year and been discounted back by 10% for each year in the future that it occurs.

Over the next 5 years the franking credits are worth $1.875.

Next we need to calculate the value of all the franking credits that occur after the 5 year period in the chart. This is where we apply the 3% long-term growth rate of dividends.

To do that we divide the year 6 expected franking credit by 7% which is the difference between the WACC and the long-term growth rate of the dividend (10% - 3%). That gives us a terminal value of $8.08. When discounted back to today those franking credits are worth $5.02.

In total this gives us a value of the franking credits of $6.895.

How does this impact what we would pay for a share

In a world with a certain future there is a strong case to be made that the hypothetical Aussie share is worth close to $7 more than the global share.

The problem is that we don’t live in a certain world. A lot of things need to happen for the future I outlined to occur. The company needs to continue to be profitable and pay taxes on that profit to generate the franking credits to pass along to shareholders.

The company needs to be profitable to pay dividends in the first place. There is a myriad of factors that will influence how much profit a company makes.

If the company continues to grow profits management needs to decide to pay dividends at the rate I outlined. And finally, the government needs to continue the current policy towards franking credits. This is no guarantee.

When an analyst is estimating what will happen in the future they do a lot of work to come up with the scenario that is captured in the model. But as you can see there are a lot of variables at play for the franking credits to be worth $6.895.

And that is why we need a margin of safety. The margin of safety accounts for the imprecision of this estimate about the future.

At Morningstar we look at the uncertainty of future outcomes and set a margin of safety based on the attributes of each company. Some businesses are just riskier by nature. That makes it harder to predict the future. I've written more about business risk in this article.

The margin of safety for different companies we cover range from 20% for low uncertainty companies to 75% for extreme uncertainty. The risk of the franking credits are mostly specific to the business as they relate to the future cash flows generated by the company. There is additional risk related to government tax policy.

For a high uncertainty business our analysts believe a 40% discount is warranted. Assuming my hypothetical Australian company is a high uncertainty business I would bump it up a level to very high to account for changes in tax law. That is a 50% discount. The franking credits are now worth $3.45.

This is a reasonable valuation. Overall franking credits were responsible for around 22% of ASX 200 total returns. Given the yield on my hypothetical share was low compared to ASX shares it makes sense that the value of the franking credit was approximately 10% of the share price.

Final thoughts

In this hypothetical scenario the same share listed in Australia would be worth around 10% more to an Australian investor than the global share. As investors our job is to identify value and then determine if that value is priced appropriately. If there is difference between value and price it is an opportunity.

There are lots of arguments to suggest that franking credits are appropriately valued. Most investors know about franking credits and many use franking credits to justify portfolios that are heavily weighted to Australian shares.

The contrasting argument is that franking credits are only valuable to certain investors. A non-Australian who owns an Australian share doesn’t benefit from a franking credit. This asymmetry of value creates the potential for mispricing.

This is a complicated questions to answer. But I’ve got another take on it. In my scenario I’ve created a situation that just doesn’t exist in real life. The Australian company would be more valuable to an Australian investor than the exact same company listed overseas. But no two companies are the same.

I worry that many Australian investors are overvaluing franking credits. And this is causing those investors to ignore global shares which may have better prospects for dividend growth and share price growth.

Franking credit added around 2% to ASX 200 returns. That is a significant amount. But I’ve also pointed out that the outlook for Australian dividend payers in the banking and resource sectors don’t look great.

Investors ignore valuation at their peril. And part of the reason that investors work so hard to estimate the value of a share is to provide some ballast in a volatilile market. Franking credits are no different. They are valuable. But their value must be considered in relation to other things that are valuable – earnings growth and dividend growth are valuable too. They are two key drivers of investor outcomes.

Don’t ignore franking credits. They make a big difference in returns. But don’t fall into the trap of ignoring compelling opportunities just because they don’t provide franking credits. That is the key to building a holistic portfolio that will help you achieve your goals.