Changes in Aggregate Dividends Signal

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:[email protected]

D. Michael Long

UBS Associate Professor of Finance

University of Tennessee - Chattanooga

(423) 425-2296 (O)

Email: [email protected]

JEL classification: G35; G14

Keywords: Dividends; Signaling; Excess Cash; Ratchet Effect


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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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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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