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8/3/2019 Changes in Aggregate Dividends Signal
1/23
Do Liquidity Induced Changes in Aggregate Dividends
Signal Aggregate Future Earnings Growth?
*Christi Wann
Assistant Professor of Finance
University of Tennessee - Chattanooga
Department of Finance, COB
615 McCallie Avenue
Chattanooga, TN 37403
(423) 425-1722 (O)
423-763-4076 (H)
Email:Christi-Wann@utc.edu
D. Michael Long
UBS Associate Professor of Finance
University of Tennessee - Chattanooga
(423) 425-2296 (O)
Email: Michael-Long@utc.edu
JEL classification: G35; G14
Keywords: Dividends; Signaling; Excess Cash; Ratchet Effect
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Do Liquidity Induced Changes in Aggregate Dividends
Signal Aggregate Future Earnings Growth?
Abstract
Extant empirical literature does not provide abundant evidence for the information contenthypothesis regarding firm-level dividend signaling. Although this is consistent with Miller andModiglianis (1961) argument against an optimal firm-level dividend policy, this does not implyan absence of an optimal aggregate dividend policy. Aggregate dividends and earnings mayexhibit stronger associations if aggregation filters out firm-specific earnings information andindicates macroeconomic trends (Marsh and Merton, 1987). Using macroeconomic data, weshow that aggregate payout ratios signal aggregate future earnings growth for horizons up to 4years, and that excess aggregate liquidity plays an important role in this relationship.
JEL classification: G35; G14
Keywords: Dividends; Signaling; Excess Cash; Ratchet Effect
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Do Liquidity Induced Changes in Aggregate Dividends
Signal Aggregate Future Earnings Growth?
Introduction
In a recent survey of 384 financial executives, Brav, Graham, Harvey, and Michaely
(2004) confirm Lintner's (1956) observation that managers only increase dividends when strong
earnings are sustainable in the future. However, extant empirical literature provides limited
evidence that dividend changes signal future earnings growth at the firm level. Nissim and Ziv
(2001) find that dividend increases signal future abnormal profits. Conversely, Benartzi,
Michaely, and Thaler (1997), and subsequently, Benartzi, Grullon, Michaely, and Thaler (2003)
find no evidence that dividend changes signal future earnings growth. The lack of consistent
evidence between theory and corporate practice is puzzling.
Although Miller and Modigliani (1961) argue that there is no optimal dividend policy at
the firm level, this does not imply that there is no optimal dividend policy at the macroeconomic
level. Marsh and Merton (1987) find that aggregate dividends display systematic time series
behavior, casting doubt on the ability of firm-specific dividend behavior to wholly explain the
dividend puzzle. The relationship between aggregate dividends and aggregate earnings may
actually be stronger than firm-level relationships if aggregation filters out firm-specific earnings
information and signifies macroeconomic trends. This is further strengthened by Marsh and
Mertons (1987) suggestion that firms consider industry payout ratios when choosing a target
payout ratio.
Prior research has paid less attention to aggregate data than firm-level data. Therefore,
we expand the current research by utilizing macroeconomic data provided by the Federal
Reserve Statistical Releases. In addition, other research largely ignores the effect that underlying
economic stimuli may have on aggregate changes in dividend payout policy and subsequent
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future earnings growth. For example, changes in aggregate cash balances (liquidity shocks) may
help provide a context in understanding the relationship between changes in payout policy and
changes in future earnings growth. In fact, we find that aggregate payout deviations from
Lintners (1956) long-run target ratio following a liquidity shock signal aggregate future earnings
growth.
Thus, the purpose of this paper is to provide new evidence concerning the relationship
between changes in dividends and future earnings. In this process, we make several empirical
contributions. First, we extend prior research by investigating the role that a latent economic
variable, such as increases in excess cash balances (liquidity shocks), may have in relating
payout ratio to changes in future earnings growth. For example, we find increases in aggregate
payout ratios, if induced by positive liquidity shocks, predict higher aggregate future earnings
growth. Second, to the best of our knowledge, we are the first to use the aggregate
macroeconomic data supplied by the Federal Reserve to reexamine the role that changes in
dividend policy may have in signaling changes in future earnings.
In addition, we present further evidence of Lintner's (1956) ratchet effect. Simply
stated, this effect suggests firms are reluctant to cut dividends, and will only increase dividends if
supported by higher expected earnings. If true, then aggregate dividends need to grow when the
current payout ratio is below the aggregate long-run target payout, and remain unchanged when
payout is above the target. Consequently, a long-run target payout ratio is maintained if earnings
grow when the current payout ratio is higher than target, and remain unchanged when payout
ratios are lower than target. Lastly, we provide additional support for a long-run aggregate target
payout ratio.
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Literature Review
One of the first studies addressing dividend policy is based upon interviews with
executives of a select group of firms to determine what factors are considered when setting
dividend policy (Lintner, 1956). He used the results to develop a model to explain changes in
dividend policy. Lintner finds that firms set dividend policy first, symbolic of the high
importance assigned to stable dividends. Furthermore, changes in dividends are primarily based
upon support provided by earnings levels. Lintner suggests that firms adjust dividends to the
long-run target payout ratio asymmetrically by increasing dividends slowly and avoiding
dividend cuts. This is referred to as the "ratchet effect."
A more recent survey by Brav, Graham, Harvey, and Michaely (2004) supports Lintner's
(1956) finding that changes in dividends are primarily based upon the support and perceived
stability provided by earnings levels. Similar to Lintner's study, the survey results suggest that
firms strive to maintain dividend levels and avoid dividend cuts. Conversely, Skinner (2004)
analyzes S&P data ands finds that Lintners relationship between aggregate dividends and
aggregate earnings has declined.
Miller and Modigliani (1961) also recognize that firms are unwilling to decrease
dividends and will increase dividends only when they expect to achieve equal or higher earnings
in the future. In a study of the ratchet effect for dividends, Shirvani and Wilbratte (1997) find
support for the long-run target payout ratio implied by Lintner (1956). For example, when the
payout ratio is lower than target, dividends are allowed to grow. Conversely, growth in earnings
serves as the stabilizing factor when the payout ratio is too high. Support for a long-run target
dividend payout ratio implies that dividends and earnings must be cointegrated (Engle and
Granger, 1987).
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The ratchet effect also suggests that dividend announcements provide important signaling
content. However, much of the existing literature examines the relationship between dividend
changes and future earnings without consideration for the underlying economic conditions that
drive dividend changes.
Several other studies have attempted to relate dividend changes with future earnings
changes. Benartzi, Michaely, and Thaler (1997) test the actual realization of future unexpected
earnings in response to dividend policy changes. Surprisingly, there is not much evidence for the
expected positive relationship between dividend increases and future unexpected earnings
growth. This finding is not consistent with the notion that changes in dividends have information
content about the future earnings of firms. Grullon, Michaely, and Swaminathan (2002) further
examine the signaling hypothesis with a sample limited to firms that change their dividends by
more than 10% and use return on assets as the measure of profitability. Firms that increase
dividends actually experience declines in return on assets in the following three years. Likewise,
firms that decrease dividends experience an increase in return on assets for the next three years.
Benartzi, Grullon, Michaely, and Thaler (2003) re-evaluate the link between dividends
and earnings changes using Fama and Frenchs (2000) modified partial adjustment model. The
strength in this methodology lies in the ability to relate future earnings to past earnings, and
thereby control for the predictable component of earnings. Once again, no support for the
information content hypothesis is found.
In contrast, there is support for the information content hypothesis in an aggregate study
of the payout ratio of the U.S. equity market portfolio (Arnott and Asness, 2003). Expected
future earnings growth, measured as EPS on an index fund holding the S&P 500, is fastest when
payout ratios are high and slowest when payout ratios are low.
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Further support for the information content hypothesis is in a study examining the
increased propensity of firms to pay dividends (Julio and Ikenberry, 2004). Although Fama and
French (2001) find that the number of firms paying dividends declined during the late 1990s, a
reversal has taken place since 2000. One suggested reason for the reappearance of dividend
payments is that some firms have decided to use dividends as a signal of confidence amidst
investor anxiety over corporate governance. Firms with low debt levels and limited access to
capital markets began to use dividends as signals of confidence in the beginning of 2000.
One area of study that has received little attention is the markets reaction to dividend
changes in relation to liquidity levels. Guay and Harford (2000) study the permanence of cash
flow shocks and relate them to the announcement of either dividend increases or share
repurchases. When the announcement of the payout form does not match the market's
expectation concerning future cash flows, stock returns respond in the following ways. For
example, when the market perceives a permanent cash flow increase and the firm chooses a
temporary payout method, such as a repurchase, stocks experience negative returns. Likewise,
when the market has estimated a transient cash flow shock and the firm chooses a more
permanent payout, such as an increased dividend, stocks experience positive returns. These
results imply that the form of payout is related to expectations regarding the permanence of the
cash flow shock.
Another study investigates the permanence of earnings deviations to determine why stock
repurchases have fluctuated so widely (Dittmar and Dittmar, 2002). Permanent and temporary
increases in earnings are related to increases in repurchases. Dividends only increase in response
to permanent increases in earnings. Dividends and repurchases are used interchangeably in
distributing permanent earnings.
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Lie (2000) finds that firms with excess cash within their industry are also firms that
increase dividends or repurchase shares to alleviate the agency problem of free cash flow. Lie
(2000) defines excess cash flow as operating income before depreciation, minus interest
expenses, taxes, and depreciation. Stock prices of firms with excess cash only react significantly
to special dividend and repurchase announcements, and not to regular dividend increases.
Data
The sample data includes quarterly income statement and balance sheet data from table
F.102 in the Federal Reserve's Flows of Funds Release for Nonfarm Nonfinancial Corporate
Business. The macroeconomic data covers the period from 1952 Q1 to 2004 Q3 and originates
from tax files, not from financial statements. All dollar values are converted into constant 2004
Q3 dollars using the CPI provided by the Bureau of Labor Statistics.
In this section, we briefly discuss the variables used in the study, but provide more
convenient and complete definitions of the variables in Table 1. The primary focus of the study
is to examine the effects changes in payout ratios may have on changes in future earnings in the
presence of a liquidity shock. Here payout ratios are simply dividends divided by earnings
before tax. The long-run target payout ratio is a rolling average of the previous 8-quarter payout
ratios. The target adjusted payout ratio is defined as the percentage that actual payout is above or
below the long-run target payout ratio. Liquidity shock is measured as the percentage actual
cash is above or below target cash. Target or expected cash is the eight-quarter rolling average
cash-to-net-assets ratio times net assets.
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Table 1. Definitions for the main variables analyzed in the study are listed below.
Cash-to-Net Assets Ratio: the sum of checkable deposits and currency, time and savings
deposits, money market fund shares, commercial paper, and U.S.government securities all divided by net assets
Net Assets: assets minus the sum of checkable deposits and currency, time andsavings deposits, money market fund shares, commercial paper, andU.S. government securities
Target Cash: expected cash level as a fraction of net assets,
Target Cash = (t-8,t x Net Assets),
where, tt ,8 is the eight-quarter rolling average cash-to-net assets ratio
Liquidity Shock: measures excess cash balances, and is the percentage actual cash isabove or below target cash in the current period,
LS = ln[Casht/(t-8,t * Net Assetst)]*100
Earnings: profits before tax
Payout Ratio: dividends divided by profits before tax
Target Payout Ratio: the prior 8-quarter rolling average payout ratio
Target Adjusted Payout: measures the percentage actual payout is above or below targetpayout, Target Adjusted Payout = ln(Payoutt/Target Payout)*100
In Table 2 we report the descriptive statistics for the main variables analyzed in the study.
We follow the convention of Opler, Pinkowitz, Stulz, and Williamson (1999) concerning scaling
by total assets net of cash and marketable securities. The median cash-to-net assets ratio is
4.23% and the median liquidity shock equals 1.63%. The median payout ratio is approximately
29% while the median deviation from the target payout ratio is 0.53%.
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Table 2. Descriptive statistics for the main variables analyzed during the time period
1952 Q1 to 2004 Q3, at the macroeconomic level. Nis the number of non-missing
observations for each variable in the sample.
Variable Mean25th
QuartileMedian 75th Quartile
StandardDeviation
N
Cash/Net Assets 4.75% 3.61% 4.23% 5.41% 1.58% 202
Liquidity Shocks -1.47% -6.82% -1.63% 4.34% 7.38% 202
Earnings ($billion) 94.4004 74.8098 92.4527 109.4480 24.2543 202
Payout Ratio 35.61% 23.25% 28.99% 46.03% 16.71% 202
ln(Payout/Target Payout) 1.42% -9.97% -0.53% 10.43% 16.99% 202
ln(Earningst+4) 1.37% -10.48% 3.71% 12.39% 18.47% 198
ln(Earningst+8) 1.91% -14.27% 2.77% 19.88% 25.24% 194
ln(Earningst+12) 1.96% -15.13% 3.49% 21.75% 27.29% 190
ln(Earningst+16) 2.90% -16.04% 6.03% 27.76% 29.91% 186
Methodology
Variance Ratio Tests
Survey results imply that firms strive to maintain long-run target payout ratios (Lintner
1956, Brav, Graham, Harvey, and Michaely 2004), which suggests that dividends and earnings
are cointegrated. In order to test for cointegration, we apply Lo and MacKinley's (1988)
variance ratio test to payout and cash-to-net asset ratios for the time span of 1952 Q1 to 2004
Q3.1 The variance ratio test compares the size of the permanent trend component with the
temporary trend component from a time series for a particular variable. The ratio of the
permanent trend component to the temporary trend component forms the variance ratio.
Variance ratios are calculated from a four-quarter to a twelve-quarter time horizon.
1 Please refer to Lo and MacKinley (1988) for variance ratio computations.
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Table 3 contains the results of variance ratio tests for changes in payout and cash-to-net
asset ratios. In the aggregate, if firms adjust current payout and cash-to-net asset ratios to a
desired long-run target ratio, then deviations above (below) the target ratio should be followed
by downward (upward) adjustments. Consequently, changes in the variables studied should
exhibit negative correlation.
The results presented in Table 3 indicate that changes in payout ratios and cash-to-net
assets do not follow a random walk for up to eight quarters, and those changes are in fact mean
reverting at a significance level of p=0.01 and p=0.05, respectively. This implies that over 8-
quarters in the aggregate there is a collective attempt to maintain a target ratio by raising payout
and cash-to-net ratios when they are below target, and by lowering payout and cash-to-net when
they are above target. It is this process of reverting to a mean target that allows deviations from
the target to convey information about future earnings growth.
Based on this analysis, we use the 8-quarter rolling average payout ratio as the long-run
target ratio. The target payout ratio is then used to calculate the degree actual payout deviates
from the target. Similarly, we use the 8-quarter rolling average cash-to-net assets ratio as a
benchmark to calculate liquidity shocks or periods of increases in excess cash balances.
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Table 3. Variance Ratio Tests.
Numbernq of base
observations
Number q of base observations aggregated to formvariance ratio
4 8 12 16
Dividends/Earnings
Variance Ratio 211 0.47 0.32 0.23 0.21
Test Statistic (-1.85)* (-1.71)* (-1.65) (-1.56)
Implied Correlation -0.18 -0.10 -0.07 -0.05
Cash/Net AssetsVariance Ratio 211 0.51 0.42 0.58 0.60Test Statistic (-3.26)*** (-2.38)** (-1.32) (-1.09)Implied Correlation -0.18 -0.10 -0.07 -0.03
Notes: Dividends, earnings, cash, and net asset variables are stated in constant 2004 Q3dollars, and are used in variance ratio tests for random walk. Dividends exclude net share
issues and earnings are profits before tax. denotes the total number of quarterlyobservations over the period 1952Q1 to 2004Q3 in the variance ratio test.
n
*, **, *** denotes significance at the 10%, 5%, and 1% levels, respectively.
Regression Analysis
In the following regression analysis, we examine the effects of several scenarios relating
changes in dividends (with and without liquidity shocks) to future earnings growth. Each
regression is estimated over the sample period of 1952 Q1 to 2004 Q3 using Maximum
Likelihood estimation and corrected for autocorrelated errors. The time horizon ranges from
four to sixteen quarters, or one to four years.
As noted earlier, prior surveys of business executives suggest dividends are only
increased when strong earnings are sustainable. However, there is not strong empirical evidence
that dividend changes signal future earnings growth. Using aggregated data we reexamine this
issue in our first regression. Equation (1) measures how changes in target-adjusted payout ratios
affect future changes in earnings. If1 is significantly positive (1>0), then this is evidence that
higher target-adjusted payouts signal higher future earnings. Equation (1) is as follows:
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ln(Earningst+i) = 1 + 1ln(Payoutt/Target Payout) + (1)
In equation (2) below, we introduce an interactive variable to capture the effects of
changes in payout ratios that are induced by liquidity shocks (i.e., excess cash balances). An
increase in excess cash, if perceived as permanent, can be used to permanently increase
dividends, and signal the firm's confidence in a more profitable future. Prior literature suggests
dividends are increased when permanent increases in cash flows occur (Guay and Harford 2000,
Dittmar and Dittmar, 2002). Equation (2) is as follows:
ln(Earningst+i) = 2 + 2ln(Payoutt/Target Payout)
+ 2ln(Payoutt/Target Payout)*LS + (2)
Liquidity shocks enter Equation (2) as an interactive dummy variable, where LS=1 if
actual cash balance is above target cash (liquidity shock > 0), otherwise LS=0. If 2 is
significantly positive (2>0) then a positive liquidity shock suggests that the excess cash is
perceived as permanent and signals confidence in higher future profits or earnings. It will also
convey the importance of recognizing that other economic stimuli may have a significant impact
on a firms future profitability. As in equation (1), a significantly positive 2 implies, that in
general, the market views higher payouts as a signal for higher future earnings.
As discussed earlier, the ratchet effect suggests that changes in the payout ratio may
signal different information concerning changes in future earnings growth. Therefore, in
equation (3) we examine the relationship between changes in payout, and changes in payout
induced by a liquidity shock on future earnings, when payout is above target and when payout is
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below target. To measure these effects we use two dummy interaction variables. Equation (3) is
follows:
ln(Earningst+i) = 3 + 3 ln(Payoutt/Target Payout)
+ 3 ln(Payoutt/Target Payout)*D1*LS
+ 3 ln(Payoutt/Target Payout)*D2*LS + (3)
The first interaction term measures the effect of payout changes induced by a liquidity
shock when payout ratio is above its long-run target. As in equation (2), LS=1 if actual cash
balance is above target cash (liquidity shock > 0), otherwise LS=0. In addition, the dummy
variable D1 will have a value of D1=1 if payout is above the long-run target payout, otherwise
D1=0. If, actual payout is above long-run target payout, then a firm can (1) cut dividends, or (2)
maintain current dividends and allow growth in earnings to lower the payout ratio to the target
ratio. Prior research supporting the ratchet effect suggests firms are reluctant to cut dividends
and will let future earnings catch-up to high dividends. In this case, increasing dividends when
payout is above a long-run target should provide signaling information for higher expected future
earnings. Therefore, in the first interaction term, we should find that 3 is significantly greater
that zero (3>0).
The second interaction term in equation (3) measures the effect of payout changes
induced by a liquidity shock when payout ratio is below its long-run target. Here the dummy
variable D2 will take on a value of D2=1 if payout is below the long-run target, otherwise D2=0.
Consequently, if actual payout is below long-run target payout, then dividends need to grow
relative to earnings in order to raise payout back to target. Therefore, in contrast to the previous
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case, an increase in the payout ratio here should not signal increases in future earnings. This
implies that the coefficient in the second interaction term, 3, should not be significantly
different from zero (3 =0). Again, as in equation (1), a significantly positive 3 continues to
imply that, in general, the market views higher payouts as a signal for higher future earnings.
Results
Equation (1) examines the general relationship between changes in target adjusted payout
ratios and changes in future earnings over a time horizon of four to sixteen quarters. These
results are presented in Table 4. We find that increases in payout ratios imply significantly
higher future earnings over all time periods (p=0.01). This provides support that higher payout
ratios signal higher future earnings. These aggregate results are similar to firm level studies that
find dividend changes predict future profitability (Nissim and Ziv, 2001; Chang, Kumar, and
Sivaramakrishnan, 2006; Asquith and Mullins, 1983; Healy and Palepu, 1988; Michaely, Thaler
and Womack, 1995).
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Table 4. Future Growth in Earnings and Payout Ratio Deviations from Target.
Regressions for equations (1).
1 1
Dependent Variable Intercept ln(Payoutt /Target Payout)
ln(Earningst+4) 0.0124 0.3683
t-statistic (0.41) (5.86)***
N = 198
R2= 45.34
ln(Earningst+8 ) 0.0172 0.5091
t-statistic (0.49) (7.98)***
N = 194
R2=69.71
ln(Earningst+12 ) 0.0277 0.3435
t-statistic (0.63) (5.25)***
N = 190
R2=74.51
ln(Earningst+16) 0.0469 0.3287
t-statistic (1.29) (5.09)***
N = 186
R2= 79.48
Notes: Earnings are the natural log of the cumulative sum of changes in profits before tax in future periodst+i where i denotes the number of future quarters used in the summation. t-statistics are shown inparentheses. *, **, *** denotes significance at the 10%, 5%, and 1% levels, respectively. Nis the numberof observations used in the regression.
However, we extend the analysis from equation (1) by adding an interaction variable to
capture the effects of payout changes induced by liquidity shocks. We present these results in
Table 5. The coefficient for the target adjusted payout ratio is significant for one to four year
time horizons. This implies that in the aggregate an increase in the payout ratio is a signal of
higher future earnings. What is interesting is that in order for increases in payout ratios to signal
even higher future earnings, an economic stimulus is needed. Our liquidity shock variable, as
measured by a percent increase in excess cash, appears to be that force. This effect is captured
by the 2 interaction coefficient in equation (2). We find that the 2 coefficient is significantly
positive over the 4-quarter to 12-quarter time horizon at a p-values=0.01.
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Table 5. Effect of Excess Liquidity Future Growth in Earnings and Payout Ratio
Deviations from Target. Regressions for equation (2).
2 2 2
Dependent Variable Intercept ln(Payoutt /Target Payout) ln(Payoutt /Target Payout)*LS
ln(Earningst+4) 0.0150 0.1882 0.3833
t-statistic (0.52) (2.34)** (3.45)***
N = 198
R2= 48.41
ln(Earningst+8 ) 0.0227 0.3119 0.4073
t-statistic (0.64) (3.84)*** (3.73)***
N = 194
R2=71.78
ln(Earningst+12) 0.0305 0.2021 0.3438
t-statistic (0.57) (2.56)** (2.89)***
N = 190
R2= 75.87
ln(Earningst+16) 0.0482 0.2670 0.1452
t-statistic (1.31) (3.23)*** (1.18)
N = 186
R2= 79.63
Notes: Earnings are the natural log of the cumulative sum of changes in profits before tax in future periodst+i where i denotes the number of future quarters used in the summation. LS is a dummy variable, whereLS=1 represents the presence of a positive liquidity shock, 0 otherwise. t-statistics are shown inparentheses. *, **, *** denotes significance at the 10%, 5%, and 1% levels, respectively. N is the numberof observations used in the regression.
These results support prior research by Guay and Harford (2000) and Dittmar and
Dittmar (2002). They suggest that a positive liquidity shock can be used to signal confidence in
a more profitable future if the increase in excess cash is perceived as permanent in nature.
However, without a positive liquidity shock, an increase in the target adjusted payout ratio may
be viewed as unsustainable, or only temporary, and therefore, provides less information for
signaling future earnings.
As previously outlined, the ratchet effect suggests increases in payout ratios may contain
different signaling information regarding future earnings when payout is above its long-run
target versus when it is below its long-run target. Therefore, in equation (3) we examine the
relationship between changes in payout, and changes in payout induced by a liquidity shock on
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future earnings, when payout is above target and when payout is below target. Table 6 shows the
results for equation (3). We continue to find that the coefficient for the target adjusted payout
ratio is significant (p=0.01) for up to four years.
However, we find that when payout is above target, an increase in payout ratios induced
by a positive liquidity shock predicts significantly higher future earnings across all time
horizons. This result is reflected in the 3 coefficient as presented in Table 6, which is
significantly positive for the 4-quarter through 12-quarter periods at p=0.01. Thus, it appears
that positive liquidity shocks continue to play an important role in signaling future earnings
growth around increases in aggregate payout ratios.
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Table 6. Future Growth in Earnings and Payout Ratio Deviations from Target - Liquidity Shock I
Changes ~ High Versus Low Payout Ratios. Regressions for equation (3).
3 3 3
Dependent Variable Intercept ln(Payoutt /Target Payout) ln(Payoutt /Target Payout)*D1* LS ln(Pay
ln(Earningst+4) 0.0008 0.2300 0.5226
t-statistic (0.03) (2.87)*** (4.35)***
N = 198
R2= 50.51
ln(Earningst+8 ) 0.0107 0.3293 0.5304
t-statistic (0.29) (4.17)*** (4.57)***
N = 194
R2=72.61
ln(Earningst+12) 0.0201 0.2328 0.5333
t-statistic (0.36) (2.86)*** (3.77)***
N = 190R2= 76.39
ln(Earningst+16) 0.0436 0.2852 0.1820
t-statistic (0.93) (3.40)*** (1.21)
N = 186
R2= 79.32
Notes: Earnings are the natural log of the cumulative sum of changes in profits before tax in future periods t+i wherequarters used in the summation. LS is a dummy variable, where LS=1 represents the presence of a positive liquidity shovariable, where D1=1 represents a payout ratio higher than the target payout ratio, 0 otherwise. D2 is a dummy variable, ratio lower than the target payout ratio, 0 otherwise. t-statistics are shown in parentheses. *, **, *** denotes signifilevels, respectively. Nis the number of observations used in the regression.
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In contrast, when payout is below target, we find that changes in liquidity induced payout
ratios have no significant impact on future earnings in all four time horizons (3=0). However,
the finding that 3 is insignificant does not necessarily imply that a positive liquidity shock is not
perceived as a permanent increase in excess cash balances. It is probably a consequence of the
ratchet effect, because when payout is below long-run target payout, dividends need to grow
relative to earnings in order to raise payout back to it long-run target ratio. Therefore, even if the
liquidity shock is viewed as permanent, its role in this case will be to help restore the current
payout ratio back to its long-run target as dividends increase. Thus, it is not a signal for
significantly higher future earnings.
However, the ratchet effect also suggests that firms are reluctant to cut dividends. So,
when payout is above its long-run target, firms will restore the payout target through higher
future earnings, not by cuts in dividends. So an increase in dividends when payout is above
target is a signal that management is confident that higher future earnings can restore the long-
run target ratio. Thus, the ratchet effect is also further supported by the significantly positive 3
coefficient in equation (3) across three time periods.
In addition, the arguments presented above offer support for an aggregate long-run target
payout ratio. Evidence for a long-run target payout is further strengthened by the variance ratio
tests in Table 3. This test shows payout ratios are mean reverting and do not follow a random
walk over an 8-quarter time horizon.
Conclusions
Surveys of financial executives suggest that managers only increase dividends when
strong earnings are sustainable in the future. In contrast, empirical literature provides mixed
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evidence that dividend changes signal future earnings growth at the firm level. We find a strong
relationship between aggregate dividends and aggregate earnings, implying that aggregation
filters out firm-specific earnings information and signifies macroeconomic trends. Using
macroeconomic data provided by the Federal Reserve Statistical Releases, we show that changes
in aggregate payout ratios, driven by positive liquidity shocks, do have information content about
aggregate future earnings growth for horizons up to four years. After accounting for the
economic stimuli of liquidity shocks, measured as increases in excess cash balances, we show a
significant relationship between changes in target adjusted payout ratios and future earnings
growth.
However, the impact of liquidity shocks on future earnings is concentrated when the
payout ratio is above its long-run target payout. We find increases in liquidity induced payout
ratios have no significant signaling information when payout is below its long-run target ratio.
This result is explained by and provides further evidence for the ratchet effect, as well as a long-
run aggregate payout ratio target.
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