ROIC What You Mean

Similar names, similar goals, but very different modus operandi. I see you shaking your head, wondering what I'm talking about. I'm talking about return on equity (ROE) and return on invested capital (ROIC).

These two formulas measure management's effectiveness at deploying capital. The difference? ROE measures the return on capital contributed by shareholders only, while ROIC measures the return on all capital employed, including debt. If you're unfamiliar with these concepts, read up on ROIC and ROE, and rejoin us when you're done.

Ready? Good. I'll give you a word of caution -- there are different formulas for ROIC floating about, all of which are valid, but since I trust my friends at the Fool's School, I'll use their formula.

ROIC = After-Tax Operating Earnings / (Total Assets - Non-interest Bearing Current Liabilities)

ROE = Net Income / Shareholders Equity

ROE is generally the more important of the two formulas, used effectively by Tom Gardner and company in the Motley Fool Hidden Gems newsletter. Yet ROE can be quite deceiving at companies weighted down with debt. ROIC cuts through this deception by measuring management's use of capital before financing considerations, eliminating the multiplier effect of leverage on ROE. As we'll see, leverage can dramatically boost ROE by reducing the relative equity base, making an inefficient company look proficient.

A case in point would be former market darling General Electric (NYSE: GE  ) . GE's ROE was a respectable 20% in 2003, yet ROIC was much lower at 4%, which doesn't even cover the cost of capital. Management has obviously done a poor job utilizing the company's vast resources, and for that rate of return, GE might be better off investing in treasury bonds.

Anheuser-Busch (NYSE: BUD  ) is a similar but different story. ROE was an astounding 76% in 2003, up from 36% in 2000, an incredible return at first glance. However, a closer look reveals that while earnings have certainly increased, the equity base has dwindled thanks to aggressive share repurchases. ROIC gives us a more meaningful analysis, coming in at 18% in 2003, up from 14% in 1999. Unlike GE's, Anheuser-Busch's ROIC is greater than the cost of capital, an indication that management is effectively deploying capital.

Simply put, ROIC is a more meaningful method of evaluating the operational efficiency of highly leveraged companies and should be used in conjunction with, not in place of, ROE.

Fool contributorChris Mallonalways looks at both measures when evaluating companies. He owns shares of Anheuser-Busch through his private investment partnership.

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