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.

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.

This week’s episode looks at the impact of franking credits on investor returns.

You can find the full article here.

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The full transcript of the podcast can be found below:

[Advertisement: Investing Compass is a podcast we started to explore the fundamentals of investing and help you with achieving your financial goals, whatever they may be.

ANZ's 5 in 5 have sponsored this episode of Investing Compass. We also listen to 5 in 5 ourselves to keep up to date with the latest economic, markets, and business news each weekday. One of the things that we like about the podcast is that it has a similar approach to us. They leverage the insightful experts that they have across their global network to provide a rounded and level-headed analysis of news and insights each weekday.

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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Well, today, Shani, we are talking about franking credits.

Jayamanne: Everybody loves franking credits.

LaMonica: They do, Shani, but sometimes when we love something, we form an emotional attachment to it, and we no longer think rationally. And I think that that's fine if you love a person, but it's not so great when it comes to investing.

Jayamanne: That's really profound, Mark. You've started a new column on Morningstar.com.au called Mark to Market, which I think everyone should go read. I think it's great. But maybe you should do a relationship column.

LaMonica: Yeah. I mean, I think, for example, if we turn this podcast into a relationship podcast, we would probably have a bigger audience. And I recently read there's this woman that started – and I've never listened to it – but she started this podcast called Call Me Daddy. And she just signed a $125 million contract. So, I don't know. I'm not great with details, but I don't think anyone's offered us a contract that big.

Jayamanne: Okay. It's called Call Her Daddy, but okay.

LaMonica: Not Call My Daddy?

Jayamanne: No.

LaMonica: Call Her Daddy. Okay.

Jayamanne: Yes.

LaMonica: Do you listen to this?

Jayamanne: I've listened to a few episodes, yeah.

LaMonica: Do you think that she deserves $125 million?

Jayamanne: I'm not sure about that actually, but she seems to be very popular. It's very different to our podcast.

LaMonica: Okay. I'll have to give it a listen.

Jayamanne: Okay. But I just think we're pretty lucky to have our jobs, to be honest.

LaMonica: We definitely are.

Jayamanne: So, let's unpack your strange statement comparing the emotional attachment of a significant other and a franking credit.

LaMonica: All right. I mean, if we must, Shani, I think the point is that when we're investing, we want to rationally assess investment opportunities so we can try and make better decisions. And that includes franking credits. So franking credits are valuable, but we should try and figure out what their actual value is because that can help when making decisions. For instance, we are deciding between investing in a global share with no franking credits or a local share.

Jayamanne: So why don't we start with the definition? 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.

LaMonica: And franking credits can offset other taxes owed, or they can also just be cash payments to shareholders if the franking credits exceed the total taxes owed. So, some investors in lower tax brackets will receive a refund from the ATO. Investors in higher tax brackets will receive an offset against taxes that they owe. And in this way, all Australian investors who own Australian shares benefit from franking credits.

Jayamanne: And since franking credits put money in investors' pockets, they do have value. And in this podcast, we're going to attempt to quantify that benefit. So, there's a formula used to calculate the value of a franking credit. And a podcast is never the best place to talk about formulas. But if you divide a dividend by 1 minus the company tax rate, minus the dividend amount, divided by the franking percentage.

LaMonica: Okay, so don't worry if you didn't get that. So, there are lots of online calculators that will just do this for you. So, it's like – I don't know – obviously, we went to school in very different decades, Shani, but I spent a lot of time sitting around learning long division. And then all of a sudden, somebody just hands you a calculator or maybe an abacus in my case.

Jayamanne: Mark, if you make jokes about yourself, I don't get to make jokes about you.

LaMonica: Sorry, am I stealing your thunder here?

Jayamanne: You are. But it's very Aussie of you. You're becoming a lot more self-deprecating. That's the kind of humor we like.

LaMonica: Okay. I mean, I do feel like I've always been that way. But anyway, it's a long podcast, Shani. I'm sure there'll be other jokes you can make at my expense. But first, we just want to remind you that if you want to hear the top five global market updates from around the world, click the link in the description for 5 in 5 with ANZ podcast.

So, we talked about the formula. We said there are online calculators. But why don't we run through a quick example? For most Australian-listed companies, the tax rate is 30%. So, we can calculate the value of a franking credit for a company that pays a $1 dividend that is 100% franked. So, if you use that formula or the calculator, the answer is $0.43. So, Shani and people listening, remember that number because we're going to come back to that.

Jayamanne: All right. But let's first look at the influence that franking credits have on the overall Australian market. Between 2011 and 2022, franking credits added around 2% to the ASX 200 returns, which represented 22% of total returns in the period covered in this period. That is meaningful. So franking credits really do matter.

LaMonica: But we do need to add some context. So, in the last 10 years, the U.S. market has outperformed the Aussie market by close to 8.5% a year. So, if you go back those last 10 years, franking credits would not have made up for the return shortfall.

Jayamanne: And that's of course the past. What matters is the future. We're going to attempt to answer the question of how much future frankings are worth to investors. And this comes in handy when investors are choosing between different investment options.

LaMonica: And just a reminder that valuing any investment is an educated guess, or sometimes just a guess. We want to make it 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.

Jayamanne: And a good place to start is with the principles of valuing an asset. There are three things needed to value any asset. So, the first is that the value of any asset is the cash flows generated in the future. That is to have a share, a bond, real estate investment, or a new project a company is considering. And then 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. So, if someone offered to give you $1,000 today or $1,000 in five years, you would obviously 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.

LaMonica: And remember that a franking credit is simply a cash flow that an Australian investor owning an Australian share is entitled to. So, for this exercise, we're going to use two different shares that are exactly the same with the difference being that one is Australian and one is global.

Jayamanne: And this exercise would also be applicable to an Australian share and an Australian real estate investment trust or REIT as they do not provide franking credits. It would be applicable to an ETF which owns Australian shares and an ETF that owns global shares.

LaMonica: Okay, so we're going to go through our hypothetical share, Shani. It has a dividend yield of 2.5% and it paid a dividend of $1 last year. In the last five years, the Australian shares dividend was 100% franked. The franking credit is therefore worth $0.43. That's a number we said to remember. And we calculated that, of course, at the beginning of this podcast. This gives us the foundation for estimating the value of the franking credit, but I'll provide the other information as we go through this exercise. And we're going to use the Morningstar research methodology to do this.

Jayamanne: So, our analysts create a discounted cash flow model to estimate the fair value of a share. This is a simple way to apply the valuation principles that were outlined earlier. And the first thing our analysts do is project cash flows into the future. And this is a pretty difficult exercise. It becomes more difficult as the analysts look further into the future. That's why our analysts stop at five years for most companies and 10 years for some. We're going to use five years for this exercise.

LaMonica: And that, of course, doesn't mean that a company will stop generating cash flows after the five-year period. In this case, our analysts will apply an assumed growth rate in cash flows after that initial period. And we can do this for our franking credits. We're going to assume the company is going to grow dividends at an annual rate of 5% for the next five years and 3% afterwards. We will assume the 100% franking is maintained in the future.

Jayamanne: 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 or the WACC to do this. In this case, we will assume a 10% WACC. First, we can calculate the value over the next five years. The value of the franking credit has grown 5% a year and has been discounted back by 10% for each year in the future that it occurs.

LaMonica: All right. So, we'll do the math for you. And if you can do that in your head, it's very, very impressive.

Jayamanne: And you probably shouldn't be listening to this podcast. You should be out there doing something else.

LaMonica: Yeah. You should start the podcast, Call My Daddy. Shani has been laughing about that the entire time, by the way.

Jayamanne: Poor Will has to edit out all my laughter because I just thought like what would be the premise of a Call My Daddy podcast.

LaMonica: Well, we're not going to go into that.

Jayamanne: Okay.

LaMonica: But anyway, what are those franking credits worth? So, in the next five years of franking credits you would receive, in our little estimate, they're worth $1.875. So next, we need to calculate the value of the franking credits that occur after that five-year period. And this is where we apply the 3% long-term growth rate of dividends.

Jayamanne: To do that, we divide the year six expected franking credit by 7%, which is the difference between the WACC and the long-term growth rate of the dividend, 10% minus 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 $6.89.

LaMonica: All right. So, if anyone is still awake, and I do understand that it's a little difficult to follow math on a podcast, but what matters is the concept. So, hang in there because what we want to figure out is how franking credits influence the price you would pay for a share.

Jayamanne: 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 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.

LaMonica: And of course, the company needs to be profitable to pay dividends in the first place. So, there are a ton of factors that will influence how much profit a company makes. The company continues to grow profits, management needs to decide to pay dividends at the rate that we outlined in the example. And finally, the government needs to continue the current policy towards franking credits. There is no guarantee in this.

Jayamanne: When an analyst is estimating what will happen in the future, they do a lot of work to come up with a 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 $6.89.

LaMonica: And this 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. This makes it harder to predict the future.

Jayamanne: 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 businesses as they relate to the future cash flows generated by the company. There is additional risk related to government tax policy.

LaMonica: For a high uncertainty business, our analysts believe a 40% discount is warranted. So, assuming this hypothetical Australian company is a high uncertainty business, I would bump it up to a level of very high to account for the changes in tax law. So, let's just say a 50% discount. Franking credits are now worth $3.45, and I think this is reasonable. Overall, franking credits were responsible for around 22% of the ASX 200 total returns. Given the yield on this hypothetical share was low compared ASX shares, makes sense that the value of the franking credit was approximately 10% of the share price. In this hypothetical scenario, the same share listed in Australia would be worth around 10% more to an Australian investor than a global share. As investors, our job is to identify value and then determine if that value is priced appropriately. There is a difference between value and price, it could be an opportunity.

Jayamanne: 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.

LaMonica: But guess what, Shani? There is a contrasting argument and that's 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.

Jayamanne: And this is a complicated question to answer, but we've got another take on it. In the scenario that we've outlined, the situation 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.

LaMonica: And I think our worry is 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. The question is, will income growth in Australia continue to be strong? And as we've discussed on here before, potentially there are some issues with the prospects in the banking and resource sectors that make up so much of the local market.

Jayamanne: And 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 volatile 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're two key drivers of investor outcomes.

LaMonica: So, I think the message in all of our confusing math is 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. The key is to build a holistic portfolio that will help you achieve your goals.

All right, we made it to the end. And just so everyone knows, Will needs to get on a plane. And Shani repeatedly laughing at Call My Daddy during this has not helped. But thank you very much for listening. Thank you for putting up with all of the math that is difficult to follow on a podcast. We would appreciate any comments you have.

[Advertisement: Investing Compass is a podcast we started to explore the fundamentals of investing and help you with achieving your financial goals, whatever they may be.

ANZ's 5 in 5 have sponsored this episode of Investing Compass. We also listen to 5 in 5 ourselves to keep up to date with the latest economic, markets, and business news each weekday. One of the things that we like about the podcast is that it has a similar approach to us. They leverage the insightful experts that they have across their global network to provide a rounded and level-headed analysis of news and insights each weekday.

You can find them in your preferred podcast player or click the link in the episode description to follow them and have a listen after us.]

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)