that price-to-book ratios might be even more important than price-to-
earnings ratios in predicting future cross-sectional stock returns.^20
Like P-E ratios and dividend yields, Graham and Dodd considered
book value to be an important factor in determining returns:
[We] suggest rather forcibly that the book value deserves at least a fleeting
glance by the public before it buys or sells shares in a business undertak-
ing.... Let the stock buyer, if he lays any claim to intelligence, at least be
able to tell himself, first, how much he is actually paying for the business,
and secondly, what he is actually getting for his money in terms of tangi-
ble resources.^21
Although Fama and French found that the ratio of book to market
value was a slightly better value metric than the dividend yield or P-E
ratio in explaining cross-sectional returns in their 1992 research, there
are conceptual problems with using book value as a value criterion.
Book value does not correct for changes in the market value of assets,
nor does it capitalize research and development (R&D) expenditures.
In fact, over the time period 1987 through 2006, our studies showed
that book value underperformed either dividend yields, P-E ratios, or
cash flows in explaining returns.^22 Since it is likely that an increasing
fraction of a firm’s worth will be captured by intellectual property,
book value may become an even more imperfect indicator of firm
value in the future.
COMBINING SIZE AND VALUATION CRITERIA
The compound annual returns on stocks sorted into 25 quintiles along
size and book-to-market ratios from 1958 through 2006 are summarized
in Table 9-5.^23 Historical returns on value stocks have surpassed growth
stocks, and this outperformance is especially true among smaller stocks.
The smallest value stocks returned 19.59 percent per year, the highest of
any of the 25 quintiles analyzed, while the smallest growth stocks re-
turned only 5.97 percent, the lowest of any quintile. As firms become
larger, the difference between the returns on value and growth stocks be-
152 PART 2 Valuation, Style Investing, and Global Markets
(^20) Dennis Stattman, “Book Values and Expected Stock Returns,” unpublished MBA honors paper,
University of Chicago, and Fama and French, “Cross Section of Expected Stock Returns.”
(^21) Graham and Dodd, Security Analysis, 1st ed., pp. 493–494.
(^22) Unpublished work estimating the alpha from quintile selection of value strategies from 1987
through 2006 using the data on the Fama-French Web site http://mba.tuck.dartmouth.edu/pages/
faculty/ken.french/data_library.html.
(^23) These data come from the Fama-French Web site cited in the preceding footnote.