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
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 contributor Chris Mallon always looks at both measures when evaluating companies. He owns shares of Anheuser-Busch through his private investment partnership.