What it means
Most return ratios, such as return on equity, use the book value of equity. Book value is an accounting figure that records what shareholders have put in plus retained profits, and it can be far from what the shares trade for.
ROME replaces it with market value, the current share price multiplied by the number of shares. That change shifts the question.
Return on equity asks how well management has used the money the owners invested over the years. ROME asks what profit an investor receives today for the price they would have to pay to own the company.
Because it uses market value, ROME moves when the share price moves. If profits stay the same and the share price doubles, ROME halves, and the shares look more expensive.
In this way it works as a valuation measure as much as a profitability measure. ROME is the mirror image of the price to earnings ratio.
If a share trades at 12.5 times earnings, then ROME is 1 divided by 12.5, which is 8%. Investors compare it with bond yields and other opportunities to judge whether the shares offer enough reward for their risk.
The measure has limits. Net income can be volatile or include one-off items, and market values reflect expectations about future growth as well as current profit.
A fast-growing company may have a low ROME today because investors expect profits to rise sharply, so the figure should be read with growth prospects in mind. Companies themselves watch ROME because it informs financing choices.
When the figure is very low, the shares are expensive and issuing new ones is cheap capital, whereas a high figure suggests the shares are undervalued and a buyback may make more sense.
In practice
Real-world examples.
Example
An investor compares two retailers. The first has net income of $5,000,000 and a market value of $50,000,000, giving ROME of 10%, while the second has net income of $5,000,000 and a market value of $125,000,000, giving ROME of 4%.
Example
A finance team at an acquiring company calculates ROME for a takeover target. At an offer price of $240,000,000 and net income of $18,000,000, the return is 7.5%, which the team compares with the cost of borrowing to buy it. Because the return is above the interest rate on the loan, the deal looks affordable on this measure.
Example
A pension fund manager sees that a utility share has a ROME of 6% while government bonds yield 4%. She decides that the extra 2 percentage points is a fair reward for the extra risk of holding shares and adds to the position.
Formula
Calculation
ROME = Net income / Market value of equity
Market value of equity = Share price x Shares outstanding
Suppose a company earns net income of $8,000,000 and has 10,000,000 shares trading at $10 each. The market value of equity is 10,000,000 x $10 = $100,000,000. ROME is $8,000,000 / $100,000,000 = 0.08, or 8%, which is the same as 1 divided by a price to earnings ratio of 12.5.Case study
Seen in the real world.
Kestrel Components is an illustrative, fictional listed manufacturer whose share price tripled in two years after a successful product launch. Its profit had grown, but much more slowly than the price.
The finance director calculated ROME and found that it had dropped from 9% to 4%. At that level an investor earned only 4 cents of profit for each dollar of market value, less than the company's own borrowing cost.
In this fictional case the board decided to issue new shares while the price was high, using the proceeds to repay debt. The illustrative lesson is that ROME helps a company judge whether its shares are cheap or expensive relative to its profit, which informs decisions about issuing or buying back shares. The finance director now includes the measure in every capital allocation paper presented to the board.
Watch out
Common mistakes.
- Confusing ROME with return on equity, when one uses market value and the other uses book value.
- Using a single unusually good or bad year of profit, which gives a misleading picture.
- Treating a low ROME as proof that a share is poor value without considering the growth investors expect.
Questions
People also ask.
How is ROME related to the price to earnings ratio?
ROME is the inverse of the price to earnings ratio, so a ratio of 20 gives a ROME of 5%.
Why use market value instead of book value?
Market value shows what an investor would pay today, so the resulting return reflects the actual price of ownership.
Is a higher ROME always better?
A higher ROME means more profit per dollar of market value, but it can also signal that investors see risk or weak growth, so it should be judged in context.
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