Franking credits propel returns

If you ever wondered about the power of franking, how about an increased total investment return of 58%?

Summary: Franking credits have increased total investment returns by 58% since their introduction on July 1, 1987. Investment income in 2013 (dividends plus franking credits) was 96% higher than would have been the case without franking credits.

Key take-out: Eliminating franking credits would significantly reduce investment income (by between 24% and 49%).

Key beneficiaries: General investors. Category: Shares.

Double taxation of company profits and dividends had a devastating effect on Australian investing. Franking credits, introduced on July 1, 1987, removed the penalty of double taxation. The result has been a significant increase in both total investment returns and annual investment income.

While many companies pay fully franked dividends, the average level of franking credits across the Australian stockmarket has been about 75%.

Increased total investment return by 58%

A $1,000 investment in the Australian stockmarket’s All Ordinaries index on June 30, 1987, would have grown by $13,410 to $14,410 by May 30, 2014, if all dividends and franking credits had been reinvested. Without franking credits, the total investment return would have been just $8,495, increasing the portfolio value to $9,495. Franking credits increased the total return by 58%.

The following graph shows that dividends and franking credits produced 98% of the total investment return.
Graph for Franking credits propel returns

The performance of the four components of investment return have been:

Share price increase without dividend growth (2% of total return)

Without the growth in dividends share prices would have risen $308 (from $1,000 to $1,308), because the price-to-dividends ratio rose 31%, or 1.00% per annum. This return includes the share price moves of companies which pay no dividends.

Share price increase due to dividend growth (13% of total return)

Dividend growth of 134% caused share prices to increase $1,755 (from $1,308 to $3,063), or 3.22% p.a.

The total effect of dividend growth and the rising price-to-dividends ratio increased share prices by $2,063 (from $1,000 to $3,063 at 4.25% p.a.).

Cash dividends (48% of total return)

Cash dividends increased the return by $6,432 to $8,495. This is the largest component of total return.

The total return of cash dividends plus share price increases was 8.72% p.a., for a portfolio value of $9,495. Without franking credits this would have been the total outcome for investors.

Franking credits (37% of total return)

Franking credits increased the total return by $4,915 to $13,410. It is the second-largest component of the total return. The total return with franking credits is 10.42% p.a., resulting in a portfolio value of $14,410.

Without franking credits double taxation would have reduced total investment returns by 37%.

Increased investment income by 96%

The elimination of double taxation 27 years ago increased investment income in 2013 by 96%.

Without franking credits (Double taxation)

The portfolio value at May 30, 2014 would be $9,495 and cash dividend income in 2013 would have been $370. With no franking credits, total income equals cash dividends.

With franking credits (No double taxation)

The portfolio value at May 30, 2014 would be $14,410 with total dividend income in 2013 of $727, which is 96% higher. Cash dividends were $550, plus franking credits of $177.

Effects are larger for some investors

These results are based on a portfolio of the companies in the All Ordinaries index. The index includes companies which pay no dividends, or that pay small dividends, or pay unfranked dividends, or have low levels of franking. The impact of franking credits on a portfolio of the major fully franked dividend-paying companies would be much larger.

This is an edited version of an article which first appeared in The Dividend Man, John King’s blog at John King is a director of AJK Consulting.

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