By Grainger David

(FORTUNE Magazine) – IF HOLLYWOOD WERE RUN LIKE A REAL business--instead of, say, like a clubby, insecure, award-crazy, star-groveling high school--where things like return on investment mattered, there would be one unchallenged, sacred principle that studio chieftains would never violate: Make lots of G-rated movies.

That's right, kids. One Hollywood maxim is becoming increasingly clear with every passing holiday season. No matter how you slice the movie business--by star vehicles, by budget levels, by sequels or franchises--by far the best return on investment comes from the not-so-glamorous world of G-rated films. The problem is, these movies represent only 3% of the total films made in a typical year.

Take 2003, the last year for which Motion Picture Association of America statistics are available. Of the 940 movies released that year, only 29 were G-rated. Yet the highest grossing movie of the year, Finding Nemo, was G-rated.

On the flip side are the R-rated films, which dominate the total releases and yet bring easily the worst return on investment. A whopping 646 R-rated films were released in 2003--69% of the total output--but only four of the top 20 grossing movies of the year were R-rated films.

This trend--G-rated movies are good for business but underproduced; R-rated movies are bad for business, and yet overdone--is something that has been driving economists batty for the past several years. "This is probably the main thing we've learned about the movie business over this decade," says S. Abraham Ravid, a finance and economics professor at Rutgers Business School who has done three statistical studies of the ratings problem between 1999 and 2004 (one was titled "Are They All Crazy or Just Risk Averse? Some Movie Puzzles and Possible Solutions"). "We can't find evidence that stars help a movie, and we can't find evidence that bigger budgets increase return on investment. But we do find that G-rated films consistently outperform all other types of films." Economist Arthur De Vany at the University of California at Irvine agrees. "G films dominate everything. They have higher returns at lower risk. We called that an arbitrage opportunity for Hollywood, which is basically a risk-free transaction." Says Ravid: "If I was going to start a studio, it would make only family films."

The benefits of G movies go beyond the box office, which accounts for only about 20% of a film's earnings. With merchandise, DVD sales, and video rentals an increasingly important part of the business, consider this: When you adjust for inflation, seven out of the top-ten-performing rentals of all time are rated G. The other three are PG.

In light of those numbers, Hollywood's stance sounds a little bit like Ford saying, "Markets be damned! We're dramatically increasing the production of little orange two-door coupes--because we like them the best!" True, you obviously can't fill an entire slate with cartoons, but there does seem to be a logical argument that Hollywood is neglecting this market.

If Tinseltown hasn't quite found G-movie religion, at least PG films are coming back into favor. Five of the top ten movies at presstime were PG or G--Lemony Snicket's A Series of Unfortunate Events, The Polar Express, National Treasure, Christmas With the Kranks, and The Incredibles--and another, The SpongeBob SquarePants Movie, was No. 11. By year-end, it appears that half the top-ten-grossing films will be G or PG.

Some companies are starting to go out of their way for a PG rating. Nina Jacobson, president of Disney-owned Buena Vista Motion Pictures Group, cites National Treasure, starring Nicolas Cage. The movie was produced by Jerry Bruckheimer, who is known for R-rated macho action movies like Con Air, The Rock, and Armageddon. Recently, however, Bruckheimer has been churning out titles like Remember the Titans and Pirates of the Caribbean. National Treasure "was a movie that could have gone either way," Jacobson says. "There was a little one-liner in the film where Cage's sidekick jokes that in jail, he's going to be 'Passed around like a pack of cigarettes.' It didn't service the story, and we decided to cut it." The film got a PG rating and, despite lackluster reviews, opened at No. 1--a spot it held for three weeks.

One major change to look for is an increase in live-action family films. Though animated films have tended to be more successful (just look at the unbroken streak of Pixar hits), they also cost more and take longer to make. Lately Disney has focused on movies such as The Princess Diaries and The Rookie. "We're trying to expand the definition of what a family film can be, in order to reach a broader audience," says Jacobson. For next year Disney has lined up Herbie the Love Bug and The Chronicles of Narnia. Bruckheimer's next film is Glory Road, a true-story basketball movie. Warner Brothers has Charlie and the Chocolate Factory, while New Line is betting on a fantasy series called His Dark Materials in 2006. All those projects are signs that Hollywood is catching on--a little. As the legendary mogul Samuel Goldwyn reputedly observed, "It is better to sell four tickets than two." Oh, and it doesn't hurt to sell the DVD either. -- Grainger David