Do liquidity induced changes in aggregate dividendssignal aggregate future earnings growth?
Christi Wann
&
D. Michael Long
Published online: 29 November 2008
#
Springer Science + Business Media, LLC 2007
Abstract
Extant empirical literature does not provide abundant evidence for theinformation content hypothesis regarding firm-level dividend signaling. Althoughthis is consistent with the argument against an optimal firm-level dividend policy,this does not imply an absence of an optimal aggregate dividend level. Aggregatedividends and earnings may exhibit stronger associations if aggregation filters out firm-specific earnings information and indicates macroeconomic trends. Usingmacroeconomic data, we show that aggregate payout ratios signal aggregate futureearnings growth for horizons up to 4 years, and that excess aggregate liquidity playsan important role in this relationship.
Keywords
Dividends.Signaling.Excesscash.Ratcheteffect
JEL Classifications
G35.G14
1 Introduction
’
s(1956) observation that managers only increase dividends when strong earnings aresustainable in the future. However, extant empirical literature provides limitedevidence 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 et al. (1997), and subsequently, Benartzi et al. (2003) find no
J Econ Finan (2009) 33:1
–
12DOI 10.1007/s12197-007-9020-4C. Wann (
*
)
:
D. M. LongDepartment of Finance, COB, University of Tennessee-Chattanooga,615 McCallie Avenue, Chattanooga, TN 37403, USAe-mail: Christi-Wann@utc.eduD. M. Longe-mail: Michael-Long@utc.edu
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-specificdividend behavior to wholly explain the dividend puzzle. The relationship betweenaggregate dividends and aggregate earnings may actually be stronger than firm-levelrelationships if aggregation filters out firm-specific earnings information andsignifies macroeconomic trends. This is further strengthened by Marsh and Merton
’
s(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 ignorestheeffectthatunderlyingeconomicstimulimayhaveonaggregatechangesindividend payout policy and subsequent future earnings growth. For example, changes inaggregatecashbalances(liquidityshocks)mayhelpprovideacontextinunderstandingthe relationship between changes in payout policy and changes in future earningsgrowth. In fact, we find that aggregate payout deviations from Lintner
’
s (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 therelationship 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 earningsgrowth. For example, we find increases in aggregate payout ratios, if induced by positive liquidity shocks, predict higher aggregate future earnings growth. Second, tothe 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 dividendlevels may have in signaling changes in aggregate future earnings.In addition, we present further evidence of Lintner
’
“
ratchet effect
”
.Simply stated, this effect suggests firms are reluctant to cut dividends, and will onlyincrease dividends if supported by higher expected earnings. If true, then aggregatedividends 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 whenthe 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-runaggregate target payout ratio.
2 Literature review
One of the first studies addressing dividend policy is based upon interviews withexecutives of a select group of firms to determine what factors are considered when
2 J Econ Finan (2009) 33:1
–
12
setting dividend policy (Lintner 1956). He used the results to develop a model toexplain changes in dividend policy. Lintner finds that firms set dividend policy first,symbolic of the high importance assigned to stable dividends. Furthermore, changesin 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 toas the
“
ratchet effect
”
’
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 Lintner
’
s relationship betweenaggregate 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, Shirvaniand Wilbratte (1997) find support for the long-run target payout ratio implied byLintner (1956). For example, when the payout ratio is lower than target, dividendsare 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 ratioimplies 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 theunderlying economic conditions that drive dividend changes.Several other studies have attempted to relate dividend changes with futureearnings changes. Benartzi et al. (1997) test the actual realization of futureunexpected earnings in response to dividend changes. Surprisingly, there is not much evidence for the expected positive relationship between dividend increases andfuture 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 limitedto firms that change their dividends by more than 10% and use return on assets asthe measure of profitability. Firms that increase dividends actually experiencedeclines in return on assets in the following 3 years. Likewise, firms that decreasedividends experience an increase in return on assets for the next 3 years.Benartzi et al. (2003) re-evaluate the link between dividends and earningschanges using Fama and French
’
s(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 aggregatestudy of the payout ratio of the U.S. equity market portfolio (Arnott and Asness2003). Expected future earnings growth, measured as EPS on an index fund holdingthe S&P 500, is fastest when payout ratios are high and slowest when payout ratiosare low.
J Econ Finan (2009) 33:1
–
12 3
Search History:
Result 00 of 00
00 results for result for
p.
Do Liquidity Induced Changes in Aggregate Dividends Signal Aggregate Future Earnings Growth - Wann and Long
334
Reads
5
Readcasts
0
Embed Views
More From This User
Notes
Load more
