Is franking a free lunch …
Many D-I-Y investors skew their investment portfolios towards shares that pay franked dividends. This is particularly prevalent amongst trustees of self managed superannuation funds who appear to over value the benefit of franking credits.
There appears to be a view that franking offers “a free lunch”, resulting in its overemphasis as a driver of investment strategy.
We believe investors should not favour particular shares simply because they pay franked dividends. The usual thinking behind such behaviour is, in our view, flawed.
Four franking “myths” …
Below, we consider four franking “myths”:
Myth 1: Franking levels indicate better future share performance
Most financial analysts believe a company’s share price is driven primarily by the share market’s assessment of its after-tax earnings prospects. If they are right, then choosing one company’s shares over another based on current franking levels alone does not make sense.
Assume you have two listed companies that have the same current and prospective earnings. Company A pays tax and therefore has the ability to distribute fully franked dividends. Company B pays no tax[1] and can only distribute unfranked dividends. The table below shows the dividend each pays, assuming a 50% dividend payout ratio:
| Company A | Company B | |
| Earnings Before Tax (per share) | $1.43 | $1.43 |
| Tax Paid (per share) | $0.43 | $0.00 |
| Earnings After Tax (per share) | $1.00 | $1.43 |
| Payout Ratio | 50% | 50% |
| Dividends per share | $0.50 (fully franked) | $0.715 (unfranked) |
While Company A’s shareholders receive fully franked dividends, Company B’s shareholders would receive a higher dividend (43% higher), albeit unfranked. A shareholder should be indifferent between the dividends as they would provide the same after tax amount per share.
The above example illustrates that franking is simply a mechanism for recognising tax paid by a company and its shareholders, to avoid double taxing the same earnings. It doesn’t actually create anything.
Over the long term, the difference between the returns to Company A and Company B shareholders is related to the fortunes of each company, not to whether their dividends are franked or not.
Myth 2: Franking benefits low rate taxpayers
Some low tax rate shareholders (e.g. self managed super fund trustees) believe they get a better relative advantage (compared to higher rate taxpayers) as a result of receiving franked dividends.
While there is no doubt that they receive an absolute advantage as a result of their lower tax rate, this will be the case regardless of the level of franking.
The table below compares the after tax returns for two tax payers with different tax rates. It compares a fully franked 4.0% dividend yield and an unfranked 5.7% dividend yield.
| Taxpayer’s Marginal Tax Rate | 0.0% | 46.5% | 0.0% | 46.5% |
| Franked | Franked | Unfranked | Unfranked | |
| Dividend Yield | 4.0% | 4.0% | 5.7% | 5.7% |
| Tax Payable | 0.0% | -2.7% | 0.0% | -2.7% |
| Franking Credit | 1.7% | 1.7% | 0.0% | 0.0% |
| Net Tax | 1.7% | -0.9% | 0.0% | -2.7% |
| After Tax Return | 5.7% | 3.1% | 5.7% | 3.1% |
There is no after-tax return advantage due to the level of franking.
Myth 3: Markets incorrectly price the benefit of franking
It’s often suggested that shares offering fully franked dividends provide a benefit not available from unfranked shares. We hope that the above discussion will cause those with this point of view to reconsider.
However, even if you remain unconvinced by that discussion, it is unreasonable to expect that the share market would not adjust to allow for the claimed disparity.
Share markets are extremely efficient. They rapidly incorporate all known information and biases into share prices. The franking level of shares is not a secret and any benefit (real or perceived) is almost certainly already reflected in prices.
If you believe that you will receive a greater benefit by buying a franked share over an unfranked share, then surely you would be prepared to pay a little more for the franked share compared with the unfranked share. Investors will continue to pay up for any franking benefit until the higher price exactly offsets the benefit.
Share markets simply do not allow any obvious inefficiencies or “free lunches” to persist.
Myth 4: A smart super investment strategy – fully franked, high yielding Australian shares
An investment strategy that emphasises the level of franking is also likely to focus on higher dividend paying shares, to maximise the perceived benefit.
In addition to defying other elements of a sound investment philosophy, such an approach implies an expectation of higher income and lower growth returns, effectively ignoring the relative tax advantage of capital gains tax over income tax.
Capital gains tax offers better opportunity for tax management than franking. Tax can be discounted and deferred (sometimes indefinitely) to reduce the overall tax rate.
A franked dividend investment strategy is flawed …
In our opinion, an investment strategy based predominantly on exploiting the perceived advantages of fully franked shares is naïve.
While franking should be a consideration, as a driver of investment strategy it down plays (and even ignores) the importance of the primary variables in the portfolio construction equation – risk, liquidity, costs and a comprehensive tax approach.
An investment strategy that considers these broader issues is far more likely to meet your long term requirements.
[1] Assume that Company B has accrued losses that offset its profit and therefore does not have to pay tax for the year.