EFF/KRF: A stock's price is just the present value of its expected future dividends, with the expected dividends discounted with the expected stock return (roughly speaking). A higher expected return implies a lower price. We always emphasize that different price ratios are just different ways to scale a stock's price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job, and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another. We like BtM because the book value in the numerator is more stable over time than earnings or cashflow, which is important for keeping turnover down in a value portfolio.
Nevertheless, there are problems in all accounting variables and book value is no exception, so supplementing BtM with other ratios can in principal improve the information about expected returns. We periodically test this proposition, so far without much success.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.