Do Liquidity Induced Changes in Aggregate Dividends Signal Aggregate Future Earnings Growth - Wann...

8/9/2019 Do Liquidity Induced Changes in Aggregate Dividends Signal Aggregate Future Earnings Growth - Wann and Long

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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 level at

the macroeconomic level. Marsh and Merton (1987) find that aggregate dividendsdisplay 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 providedby 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 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, wemake several empirical contributions. First, we extend prior research by investigat-

ing 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 macroeconomic data supplied

by the Federal Reserve to reexamine the role that changes in aggregate dividend

levels may have in signaling changes in aggregate future earnings.

In addition, we present further evidence of Lintners (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.

2 Literature review

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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 asymmetri-cally by increasing dividends slowly and avoiding dividend cuts. This is referred to

as the ratchet effect.

A more recent survey by Brav et al. (2004) supports Lintners (1956) finding that

changes in dividends are primarily based upon the support and perceived stability

provided by earnings levels. Similar to Lintners 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 decreasedividends 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).

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 et al. (1997) test the actual realization of future

unexpected earnings in response to dividend 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 et al. (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 3 years. Likewise, firms that decrease

dividends experience an increase in return on assets for the next 3 years.

Benartzi et al. (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

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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 usedividends 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 markets expectation concerning future cash flows, stock returns

respond in the following ways. For example, when the market perceives a permanentcash 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 inrepurchases. Dividends only increase in response to permanent increases in earnings.

Dividends and repurchases are used interchangeably in distributing permanent

earnings.

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.

3 Data

The sample data includes quarterly income statement and balance sheet data from

table F.102 in the Federal Reserves 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

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predict changes in future earnings. 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-assetsratio times net assets.

In Table 2 we report the descriptive statistics for the main variables analyzed in

the study. We follow the convention of Opler et al. (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%.

Table 2 Descriptive statistics for the main variables analyzed during the time period 1952 Q1 to 2004

Q3, at the macroeconomic level

Variable Mean 25th Quartile Median 75th Quartile Standard deviation 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% 194ln(Earningst+12) 1.96% 15.13% 3.49% 21.75% 27.29% 190

ln(Earnings ) 2 90% 16 04% 6 03% 27 76% 29 91% 186

Table 1 Definitions for the main variables analyzed in the study

Variable Definition

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 alldivided by net assets

Net assets Assets minus the sum of checkable deposits and currency, time and savings

deposits, money market fund shares, commercial paper, and U.S. government

securities

Target cash Expected cash level as a fraction of net assets, Target Cash = (t8,tNet Assets),

where, t8,t is the eight-quarter rolling average cash-to-net assets ratio

Liquidity shock Measures excess cash balances, and is the percentage actual cash is above or

below target cash in the current period, LS=ln[Casht/(t8,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 adjustedpayout

Measures the percentage actual payout is above or below target payout,Target Adjusted Payout = ln(Payoutt/Target Payout)*100

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4 Methodology

4.1 Variance ratio tests

Survey results imply that firms strive to maintain long-run target payout ratios

(Lintner 1956; Brav et al. 2004), which suggests that dividends and earnings are

cointegrated. In order to test for cointegration, we apply Lo and MacKinleys (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 16-quarter time horizon.

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 ofp=0.10 and p=0.05, respectively.

This implies that over 8-quarters in the aggregate there is a collective attempt tomaintain a target ratio by raising payout and cash-to-net assets ratios when they are

Table 3 Variance ratio tests

Number nq of base

observations

Number q of base observations aggregated to

form variance ratio

4 8 12 16

Dividends/earnings

Variance ratio 211 0.47 0.32 0.23 0.21

Test statistic (1.85)a (1.71)a (1.65) (1.56)

Implied correlation 0.18 0.10 0.07 0.05

Cash/net assets

Variance ratio 211 0.51 0.42 0.58 0.60

Test statistic (3.26)b (2.38)c (1.32) (1.09)

Implied correlation 0.18 0.10 0.07 0.03

Dividends, earnings, cash, and net asset variables are stated in constant 2004 Q3 dollars, and are used in

variance ratio tests for random walk. Dividends exclude net share issues and earnings are profits beforetax. n denotes the total number of quarterly observations over the period 1952 Q1 to 2004 Q3 in the

variance ratio test.aSignificance at the 10% level.b Significance at the 1% level.c Significance at the 5% level.

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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 averagecash-to-net assets ratio as a benchmark to calculate liquidity shocks or periods of

increases in excess cash balances.

4.2 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. Thetime horizon ranges from four to 16 quarters, or 1 to 4 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 predict future changes in earnings. If1is significantly positive (1>0), then this is evidence that higher target-adjusted

payouts signal higher future earnings. Equation 1 is as follows:

ln Earningsti

1 1ln Payoutt=Target Payout ( 1

In Eq. 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 firms 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 Earningsti

2 2ln Payoutt=Target Payout

2ln Payoutt=Target Payout *LS ( 2

Liquidity shocks enter Eq. 2 as an interactive dummy variable, where LS=1 if

actual cash balance is above target cash (liquidity shock>0), otherwise LS=0. If 2is 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 in predicting a firms future profitability. As in

Eq. 1, a significantly positive 2 implies, that in general, the market views higher

payouts as a signal for higher future earnings.

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earnings, when payout is above target and when payout is below target. To measure

these effects we use two dummy interaction variables. Equation 3 is follows:

ln Earningsti

3 3ln Payoutt=Target Payout

3ln Payoutt=Target Payout *D1*LS

p3ln 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 Eq. 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 andallow 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 Eq. 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-runtarget, 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 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 Eq. 1, a significantly positive 3 continues to imply

that, in general, the market views higher payouts as a signal for higher future

earnings.

5 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 16

quarters. These results are presented in Table 4. We find that increases in payout

ratios predict 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 et al. 2006; Asquith and Mullins1983; Healy and Palepu 1988; Michaely et al. 1995).

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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 economicstimulus is needed. Our liquidity shock variable, as measured by a percent increase

Table 4 Future growth in earnings and payout ratio deviations from target

Dependent variable 1 Intercept 1 ln(Payoutt/Target Payout)

ln(Earningst+4) 0.0124 0.3683

t-statistic (0.41) (5.86)a

N=198

R2=45.34

ln(Earningst+8) 0.0172 0.5091


N=194R2=69.71

ln(Earningst+12) 0.0277 0.3435


N=190

R2=74.51

ln(Earningst+16) 0.0469 0.3287


N=186

R2=79.48

Regressions for Eq. 1. Earnings are the natural log of the cumulative sum of changes in profits before tax

in future periods t+ i where i denotes the number of future quarters used in the summation. t-statistics are

shown in parentheses. N is the number of observations used in the regression.aSignificance at the 1% level.

Table 5 Effect of excess liquidity: Future growth in earnings and payout ratio deviations from target

Dependent variable 2 Intercept 2 ln(Payoutt/Target Payout) 2 ln(Payoutt/Target Payout)*LS

ln(Earningst+4) 0.0150 0.1882 0.3833

t-statistic (0.52) (2.34)a (3.45)b

N=198

R2=48.41

ln(Earningst+8) 0.0227 0.3119 0.4073t-statistic (0.64) (3.84)b (3.73)b

N=194

R2=71.78

ln(Earningst+12) 0.0305 0.2021 0.3438

t-statistic (0.57) (2.56)a (2.89)b

N=190

R2=75.87

ln(Earningst+16) 0.0482 0.2670 0.1452

t-statistic (1.31) (3.23)b (1.18)

N=186

R2

=79.63


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in excess cash, appears to be that force. This effect is captured by the 2 interaction

coefficient in Eq. 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.

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

Eq. 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 below target. Table 6 shows the results for Eq. 3. We continue to

find that the coefficient for the target adjusted payout ratio is significant (p=0.01) for

up to 4 years.

Table 6 Effect of excess liquidity: Future growth in earnings and payout ratio deviations from target High versus low payout ratios

Dependent variable 3 Intercept 3 ln(Payoutt/

Target Payout)

3 ln(Payoutt/

Target Payout)*D1*LS

3 ln(Payoutt/

Target Payout)*D2*LS

ln(Earningst+4) 0.0008 0.2300 0.5226 0.0031

t-statistic (0.03) (2.87)a (4.35)a (0.02)

N=198

R2=50.51

ln(Earningst+8) 0.0107 0.3293 0.5304 0.1004

t-statistic (0.29) (4.17)a (4.57)a (0.56)

N=194

R2=72.61

ln(Earningst+12) 0.0201 0.2328 0.5333 0.0204

t-statistic (0.36) (2.86)a (3.77)a (0.11)

N=190

R2=76.39ln(Earningst+16) 0.0436 0.2852 0.1820 0.0383

t-statistic (0.93) (3.40)a (1.21) (0.20)

N=186

R2=79.32


in future periods t+ i where i denotes the number of future quarters used in the summation. LSis a dummy

variable, where LS=1 represents the presence of a positive liquidity shock, 0 otherwise. D1 is a dummy

variable, where D1=1 represents a payout ratio higher than the target payout ratio, 0 otherwise. D2 is a

dummy variable, where D2=1 represents a payout ratio lower than the target payout ratio, 0 otherwise.

t-statistics are shown in parentheses. N is the number of observations used in the regression.aSignificance at the 1% level.

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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.

In contrast, when payout is below target, we find that changes in liquidity inducedpayout ratios have no significant impact on future earnings in all four time horizons

(3=0). However, the finding that3 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 Eq. 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.

6 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 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 3 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

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