One of the recurring themes that you hear from many of the great investors is that one of the most important elements they track when evaluating management performance is what managers do with their retained earnings.

Oh, sure, top- and bottom-line growth are great. But what good are buckets of earnings when management squanders the proceeds with non-performing acquisitions, uses them to buy back overpriced shares, or does any one of a number of things that simply destroy capital? Companies that have been guilty of this in the recent past have included Vivendi (NYSE:V), which grew like wildfire in the late 1990s, including taking on a bunch of acquisitions, but all the while the company was rotting inside. Management wasted money. Ditto Hollinger (NYSE:HLR).

Shareholders who focused on the top and bottom lines for these companies without considering what was happening with the retained earnings were shocked to find out later on that it was indeed possible for companies to be both growing and mismanaged at the same time.

Fortunately, there are really only a few things you can do with a retained dollar if you're a manager: You can reinvest it into the business by increasing or updating your asset base, you can hold onto it in the form of cash or other liquid investments, you can make an acquisition, you can pay dividends, or you can buy back stock. Oh, sure, plenty of managers do some subset, such as investing in equity or assets like real estate that aren't core to operations, and some do things like increase their current or post-retirement benefits for employees, but such expenditures still fall broadly under one of the five groupings above.

Put money to its optimal use
Every once in a while you'll see some insane commentary where a writer says "dividends are for losers," which implies that every cent paid out in a dividend is one that cannot be used to reinvest in a company's growth. This is dirt-poor logic: Some companies simply require very little reinvested capital, with any additional (beyond optimal capital structure) at risk for being wasted. Why not give it back if you don't need it? That was the story when Microsoft (NASDAQ:MSFT) finally returned large amounts of cash to its shareholders: It didn't need the money, and couldn't figure out how to use it. Better, then, to return it to shareholders, even the ones grousing that the dividend meant that Microsoft was no longer "officially a growth stock," whatever that nonsense means.

The great thing about focusing capital allocation is that the past record of management is fairly easy to track. Yes, it's tough to say "X" investment generated "Y" return, but a company that has a negative return on invested capital, in aggregate, is pretty easy to spot. One of the big elements that led me to believe that Krispy Kreme (NYSE:KKD) was in big, big trouble: The company's capital allocation decisions were absolutely awful. And here the company sits, a lenders' reprieve away from being in default of its loan covenants. This is a company that had one of the best performing stocks during the period of 2000-2002 and that not long ago the toast of Wall Street. Now it's broken and in need of a turnaround. Why? Because the newly deposed managers at Krispy Kreme couldn't allocate capital properly if you gave them $5 and a very short grocery list, that's why.

Let's take a look at each of the five choices.

1. Buy back shares. We can see the good -- like when companies like UST (NYSE:UST) have long, lustrous histories of share repurchases that greatly lower the number of shares outstanding, at prices that are way below the intrinsic value of the company. We can also see the bad, like when Apple (NASDAQ:AAPL) fired up the repurchase machine in 1999 and 2000, buying more than 5.5 million off of the open market, and then sat on its hands in 2003, when the company's shares traded for only slightly above cash. You think that $1.1 billion spent in 1999 and 2000 was money well spent for Apple shareholders? Consider this: At the end of 1998, the company had (split-adjusted) 276 million shares, while today it has 408 million. That is a staggering level of dilution, upon which this $1.1 billion expenditure (or $2.69 per share outstanding today) had almost negligible impact.

Some people love share buybacks, and some don't like them at all. I think they are fantastic, so long as they are rational deployments of capital, and so long as the shares are bought at a price below the company's intrinsic value. Purchasing shares to cover options dilution at extremely high prices does not apply in either regard.

2. Redeploy into assets. This is usually a pretty good option if your goods are in demand. Costco (NASDAQ:COST) breaks out in its annual report the amount being spent each year for capital expenditures on existing facilities vs. new ones. If the company spends a billion in CapEx each year, but manages to increase revenues by $1.15 billion, that's a return on investment that would be pretty easy to accept. But you also have the problem of assets being long-tailed. Corning (NYSE:GLW) got into some trouble in the beginning of the decade, when it built magnificent new manufacturing facilities in North Carolina and elsewhere to meet demand that was drying up. And tobacco companies like Altria (NYSE:MO) have some disincentive to redeploy much capital into their core product because of stable demand, plus the risk of a lawsuit bus running them over. Better to return as much cash as possible to shareholders.

3. Pay dividends. This one may be the untouchable for most companies: Once a regular dividend is instituted, there's a pretty strong incentive to never, ever, cut it, or worse, eliminate it. These things happen, of course. In 2003, Kodak (NYSE:EK) slashed its dividend, in a signal to shareholders that all was not well. The company's shares tanked. Again, for certain industries, a big dividend may well be the best allocation of capital: They just don't need all the cash they generate.

4. Hold cash or short-term paper. This has become the default for Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb), as Warren Buffett has struggled to find investments that would offer sufficient margins of safety with the company's $30 billion-plus cash hoard. But beyond that, this is a bread-and-butter choice for many in banking and insurance: buying treasuries or other liquid assets with money they don't need to deploy now, but do need for capital coverage or might need to spend in the future. Cash is king, but too much cash lowers returns on equity. Depending on the company, this may or may not be a worry. For Berkshire Hathaway, frankly, I could not care less.

5. Make an acquisition. Some companies are masterful at acquiring growth, like General Electric (NYSE:GE) and Church & Dwight (NYSE:CHD). However, precious few acquisitions live up to expectations, and some are pretty damaging, not only in terms of the wasted capital paid on the purchase (case in point: the nine-digit valuation given to AOL in its 2000 merger with Time Warner), but also for the recurring capital needed to run the acquired company. Cable & Wireless (NYSE:CWP) shareholders learned this the hard way, when assets bought on the cheap turned into a cash-draining nightmare.

Earnings are great. Earnings that are deployed in a way that maximizes investor benefit are even better. Managers who are capable and culturally geared toward doing so over long periods of time are best of all.

Bill Mann's life ambition is to become a railbird. OK, it isn't, but still, he likes the word "railbird." At time of publishing, he held shares in Berkshire Hathaway, Costco, and UST. The Motley Fool is investors writing for other investors and has a disclosure policy.

The Fool's own capital allocation wizard is Income Investor newsletter editor Mathew Emmert. He seeks companies that offer both large dividends and large margins of safety. Acomplimentary issueis yours for the asking.