J Econ Finan (2009) 33:1–12

DOI 10.1007/s12197-007-9020-4

Do liquidity induced changes in aggregate dividends

signal 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 the
information content hypothesis regarding firm-level dividend signaling. Although
this is consistent with the argument against an optimal firm-level dividend policy,
this does not imply an absence of an optimal aggregate dividend level. Aggregate
dividends and earnings may exhibit stronger associations if aggregation filters out
firm-specific earnings information and indicates macroeconomic trends. Using
macroeconomic data, we show that aggregate payout ratios signal aggregate future
earnings growth for horizons up to 4 years, and that excess aggregate liquidity plays
an important role in this relationship.

Keywords Dividends . Signaling . Excess cash . Ratchet effect

JEL Classifications G35 . G14

1 Introduction

In a recent survey of 384 financial executives, Brav et al. (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 et al. (1997), and subsequently, Benartzi et al. (2003) find no

C. Wann (*) : D. M. Long

Department of Finance, COB, University of Tennessee-Chattanooga,
615 McCallie Avenue, Chattanooga, TN 37403, USA
e-mail: Christi-Wann@utc.edu
D. M. Long
e-mail: Michael-Long@utc.edu
2 J Econ Finan (2009) 33:1–12

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 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 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 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 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 the
relationship between changes in dividends and future earnings. In this process, we
make 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 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.

2 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
J Econ Finan (2009) 33:1–12 3

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 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 Lintner’s 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).
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 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 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.
4 J Econ Finan (2009) 33:1–12

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.
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 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 if changes in payout ratios during liquidity shocks
J Econ Finan (2009) 33:1–12 5

Table 1 Definitions for the main variables analyzed in the study

Variable Definition

Cash-to-Net The sum of checkable deposits and currency, time and savings deposits, money
assets ratio 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 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 = (δt−8,t ×Net Assets),
where, δt−8,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/(δt−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 Measures the percentage actual payout is above or below target payout,
payout Target Adjusted Payout = ln(Payoutt/Target Payout)*100

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-assets
ratio 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
Δln(Earningst+4) 1.37% −10.48% 3.71% 12.39% 18.47% 198
Δln(Earningst+8) 1.91% −14.27% 2.77% 19.88% 25.24% 194
Δln(Earningst+12) 1.96% −15.13% 3.49% 21.75% 27.29% 190
Δln(Earningst+16) 2.90% −16.04% 6.03% 27.76% 29.91% 186

N is the number of non-missing observations for each variable in the sample.

6 J Econ Finan (2009) 33:1–12

Table 3 Variance ratio tests

Number nq of base Number q of base observations aggregated to

observations 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 before
tax. n denotes the total number of quarterly observations over the period 1952 Q1 to 2004 Q3 in the
variance ratio test.
a
Significance at the 10% level.
b
Significance at the 1% level.
c
Significance at the 5% level.

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 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 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 of p=0.10 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 assets ratios when they are
below target, and by lowering payout and cash-to-net when they are above target. It

1
Please refer to Lo and MacKinley (1988) for variance ratio computations.
J Econ Finan (2009) 33:1–12 7

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.

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. The
time 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. If β1
is significantly positive (β1 >0), then this is evidence that higher target-adjusted
payouts signal higher future earnings. Equation 1 is as follows:


Δln Earningstþi ¼ α1 þ β1 lnðPayoutt =Target PayoutÞ þ ( ð1Þ
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 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:


Δln Earningstþi ¼ α2 þ β2 lnðPayoutt =Target PayoutÞ
þ λ2 lnðPayoutt =Target PayoutÞ*LS þ ( ð2Þ

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 λ2
is significantly positive (λ2 >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 β2 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 Eq. 3 we examine the relationship between changes in payout and
future earnings, and changes in payout accompanied by a liquidity shock and future
8 J Econ Finan (2009) 33:1–12

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:


Δln Earningstþi ¼ α3 þ β3 lnðPayoutt =Target PayoutÞ
þ λ3 lnðPayoutt =Target PayoutÞ*D1 *LS
þ p 3 lnðPayoutt =Target PayoutÞ*D2 *LS þ ( ð3Þ

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 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
λ3 is significantly greater that zero (λ3 >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-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 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, π3, should not be significantly different
from zero (π3 =0). Again, as in Eq. 1, a significantly positive β3 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 Mullins
1983; Healy and Palepu 1988; Michaely et al. 1995).
However, we extend the analysis from Eq. 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 1 to 4 year time horizons. This implies that in the aggregate an increase in the
J Econ Finan (2009) 33:1–12 9

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

Dependent variable α1 Intercept β1 ln(Payoutt/Target Payout)

Δln(Earningst+4) 0.0124 0.3683

t-statistic (0.41) (5.86)a
N=198
R2 =45.34
Δln(Earningst+8) 0.0172 0.5091
t-statistic (0.49) (7.98)a
N=194
R2 =69.71
Δln(Earningst+12) 0.0277 0.3435
t-statistic (0.63) (5.25)a
N=190
R2 =74.51
Δln(Earningst+16) 0.0469 0.3287
t-statistic (1.29) (5.09)a
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.
a
Significance at the 1% level.

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

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

Dependent variable α2 Intercept β2 ln(Payoutt/Target Payout) λ2 ln(Payoutt/Target Payout)*LS

Δln(Earningst+4) 0.0150 0.1882 0.3833

t-statistic (0.52) (2.34)a (3.45)b
N=198
R2 =48.41
Δln(Earningst+8) 0.0227 0.3119 0.4073
t-statistic (0.64) (3.84)b (3.73)b
N=194
R2 =71.78
Δln(Earningst+12) 0.0305 0.2021 0.3438
t-statistic (0.57) (2.56)a (2.89)b
N=190
R2 =75.87
Δln(Earningst+16) 0.0482 0.2670 0.1452
t-statistic (1.31) (3.23)b (1.18)
N=186
R2 =79.63

Regressions for Eq. 2. 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. LS is a dummy
variable, where LS=1 represents the presence of a positive liquidity shock, 0 otherwise. t-statistics are
shown in parentheses. N is the number of observations used in the regression.
a
Significance at the 5% level.
b
Significance at the 1% level.
10 J Econ Finan (2009) 33:1–12

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

Dependent variable α3 Intercept β3 ln(Payoutt/ λ3 ln(Payoutt/ π3 ln(Payoutt/

Target Payout) Target Payout)*D1*LS Target Payout)*D2*LS

Δln(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
Δln(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
Δln(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 =76.39
Δln(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

Regressions for Eq. 3. 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. LS is 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.
a
Significance at the 1% level.

in excess cash, appears to be that force. This effect is captured by the λ2 interaction
coefficient in Eq. 2. We find that the λ2 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.
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 for
up to 3 years. This result is reflected in the λ3 coefficient as presented in Table 6,
J Econ Finan (2009) 33:1–12 11

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 induced
payout ratios have no significant impact on future earnings in all four time horizons
(π3 =0). However, the finding that π3 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 λ3 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
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.
12 J Econ Finan (2009) 33:1–12

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