The One Thing to Know About Microsoft

I know it sounds ludicrous, but investors often overlook the people in charge of protecting their investments. The idea of gauging a company's leadership plays second-fiddle to other categories of analysis. However, at Fool.com, we believe careful study of effective leadership is one of the most important areas of evaluating long-term winning investments.

We like CEOs who actually work for shareholders like us. After all, we're the true owners of the business. When you're deciding whether to invest in a company, failing to vet its CEO is a big mistake. In fact, if you've overlooked the study of a company's leadership, then that's the one important area you should know about before finalizing your investment in the company.

After reviewing thousands of companies over dozens of years, we've found several crucial characteristics of quality management. Today, we'll size up the recent performance of Microsoft's (Nasdaq: MSFT) leadership, which has drawn criticism after several big failures and the lackluster release of Windows Vista.

How much skin do they have in the game?
Are Microsoft CEO Steve Ballmer's interests aligned with shareholders? Here's how the Microsoft CEO's ownership compares to that of other companies in the industry:

Source: Capital IQ, a division of Standard & Poor's.

Steven Ballmer owns almost $10 billion worth of Microsoft, or 4.72% of shares outstanding. When CEOs invest a significant amount of their net worth in their own companies, we believe they're more likely to act in ways that generate long-term gains. This will ultimately increase shareholder value and their own wealth. There's little doubt about Ballmer's enthusiasm for the company, but its strategic direction remains in doubt.

How well are they using your money?
Return on equity can help investors determine how adeptly management gets the job done. This metric combines how well management is expanding profitability, managing assets, and using financial leverage, all in one ratio. While return on equity isn't foolproof -- managers can manipulate it with excessive leverage, for example -- it does an excellent job of suggesting how effective managers are, and how well they can generate high returns on investors' capital.

Here's a look at Microsoft's recent return on equity:

Despite difficult economic conditions, Microsoft managed to grow return on equity beyond its five-year average. Consistently increasing return on equity suggests that management is either adept at cutting costs and managing assets, or is moving the company into new high-return areas. With the release of Windows 7, and a new Office refresh, Microsoft should continue to see gains in coming quarters. The bigger hit to this category has been the company's money-losing search ambitions, and its inability to gain more traction in its entertainment segment.

How productive are their workers?
Revenue per employee provides another way to gauge a CEO's effectiveness. If this metric is declining, the company might have a bloated organizational structure, or too many extra employees toiling away at new initiatives that just aren't working out. Either possibility would hint that management isn't effectively running the organization.

Source: Capital IQ, a division of Standard & Poor's.

As you can see, Microsoft's revenue per employee has dipped below its five-year average. This might mean that the company's hiring too many people, or spending too much. To better see whether Microsoft's cost controls are actually deficient, let's compare the company to its peer group once again:

Source: Capital IQ, a division of Standard & Poor's. Dollar figures in thousands.

Microsoft has higher revenue per employee, but it's trailing its peer group in terms of last year's growth versus its five-year average. Shareholders should keep a wary eye on this red flag in the coming quarters. Microsoft recently enacted a large round of layoffs to trim out its ranks. It's also worth remembering that the company uses a large base of contract workers, which makes its official employee count misleading. Overall, like all large companies, Microsoft could still squeeze large efficiencies out of its bloated corporate structure.

In the end, management aims to return capital to shareholders, especially if the company can't adequately find new high-growth areas to invest in. So we're pleased to see that:

• Dividends have increased by 5.4% annually. The company's current dividend yield stands at 2.1%.
• Its outstanding share count has dropped over the past five years. While CEOs are often tempted to retain key talent through lavish stock option awards, this tactic can dilute current shareholders if it's used excessively. If the company's stock isn't overvalued, buying back its own shares is a very tax-effective way to return capital to shareholders.

These are just a few of the factors we look for in a company's management. If you can find leaders who continually give shareholders high returns on their capital, and align their interests with yours, you've got a better chance to enjoy market-beating returns for the long haul.