What Is Return on Market Value of Equity?
Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate positive returns on book value and trade at otherwise low valuations. The market value of equity is generally accepted to be synonymous with a company's market capitalization, and the return on market value of equity is effectively the profit yield on a company's stock price.
Understanding Return on Market Value of Equity (ROME)
Return on market value of equity measures the profit yield on a company's market capitalization, which is a function of its share price and the number of its shares outstanding. Some hedge funds employ a return on market value of equity strategy to identify undervalued shares to purchase. This strategy evaluates a firm's intrinsic value and compares that value to the current observed market price of its shares.
Intrinsic value is an investor's perception of the value of an asset. Intrinsic value is calculated as the difference between the stock's current price and the option's strike price multiplied by the number of shares an option is entitled to buy.
Intrinsic value (options) = (Stock price - strike price) x number of options.
A return on market value of equity-based strategy is considered a tool used by value investors, but it also considers that future growth is an important component of assessing a stock's intrinsic value.
Calculating the Market Value of Equity
Market value of equity, also known as market capitalization or market cap, is calculated by multiplying a company's current share price by the number of available shares outstanding. A company's market value of equity is thus constantly changing as its share price fluctuates and as the number of shares it has outstanding changes. The number of shares outstanding changes as companies issue more shares, or if there is, for example, a share buyback. A company's market value of equity is crucially different from its book value of equity because the book value does not take into account the company's potential for growth, which is theoretically incorporated into the share price.
What ROME Says About a Company
A company with a high return on market value of equity suggests that it may be undervalued and worth purchasing because its profitability is large relative to its share price. On the other hand, if a company has a higher share price given similar profits, it may not be as attractive as a value buy. The return on market value of equity is also a useful measure for comparing value across companies of different sizes that have varying market caps since it is a yield and not an absolute measure.