Foolish investors know that understanding the businesses you invest in is critical. Successful investing often comes from the ability to evaluate a business' model and its current operating environment, and then being able to estimate a value for it. Buying good businesses at good prices -- where have I heard that one before?

To make sure he understood each and every business he bought, Peter Lynch, who wrote One Up on Wall Street and Beating the Street, would go through a "two-minute drill," a short story outlining his investment. The idea was that if he couldn't describe the investment story in two minutes, he didn't understand it fully. That's a great tool to improve decision-making.

Lynch's first step was to categorize each business into one of six types: fast growers, slow growers, stalwarts, cyclicals, turnarounds, and asset plays. I believe this is one of the more powerful ideas that Lynch presented; it enabled him to move beyond thinking of businesses in terms of price multiples or whether they are growth or value stocks.

Now, what does this have to with the letters X, Y, and Z? I want to take Lynch's categorization idea and use a different scheme -- one that helps me grade or rank companies. Although not as memorable or conceptual as "stalwarts" and "fast growers," each letter represents a category of businesses based on the concepts Bennett Stewart described in his book The Quest for Value. Stewart, widely recognized for developing the economic value added (EVA) metric, devised this type of grading scale as a valuable aid to understanding how a business works while identifying different types of investment opportunities.

How it works
The concept boils down to two parts. First, we categorize a company based on whether its return on invested capital ( ROIC) is greater or less than its weighted average cost of capital (WACC). Secondly, the company is categorized by how much opportunity it has to reinvest its operating profits back into its business. Using these categories can help us understand whether a business is creating or destroying value and whether management is allocating shareholders' capital properly.

Some definitions
To calculate ROIC, we need to know the net operating profit after taxes (NOPAT). NOPAT is the operating cash flow the company has to reinvest in its business or distribute to its capital holders and removes any non-operating income or any interest on capital used to finance the company's operations.

The assets responsible for generating the firm's NOPAT are called the firm's invested capital (IC). IC should include off-balance sheet items such as capitalized operating leases, as well as stock-option grants.

The dollar cost of capital is the weighted average cost of the capital times the average invested capital employed during the year (the average of the invested capital at the beginning and the end of the time period). If NOPAT is greater than dollar cost of capital, then the firm creates value by generating economic profits.

Free cash flow to the firm (FCFF) is the free cash flow available to those financing the assets, both debt and equity, after the company has reinvested funds into the business. It is the difference between NOPAT and the change in IC over the measured time period.

Now that we have the basic definitions, it's time to define the five grades and to give an example of a company in each category. And to make the concept come alive, I'll provide links to articles that explain why each company deserves the grade it received.

Company X
If a company earns its cost of capital, such that NOPAT is equal to the dollar cost of capital, then it's neither creating nor destroying value. The company's value should track the invested capital in the business. To qualify, the firm's return on invested capital has to be within plus or minus 2.5% of its cost of capital on average for the past five years. Kroger (NYSE:KR) is an X company.

Company X-minus
If a company earns less than its cost of capital, such that NOPAT is less than the dollar cost of capital, then the company is destroying value, because the company does not generate enough return to cover its cost of capital. An X-minus firm can generate positive free cash flow but should not reinvest capital back into the business. X-minus firms often trade below their IC, reflecting the low profitability of their assets. Stein Mart (NASDAQ:SMRT) is an X-minus company.

Company Y
If a company's operating profits are greater than its cost of capital, such that ROIC is 2.5% greater than WACC, then the firm is creating value. Firm Y, however, doesn't have enough projects to reinvest its operating profits and therefore generates strong free cash flow, which is often distributed to its shareholders. AutoZone (NYSE:AZO) is a Y company.

Company pre-Z
As the name implies, a pre-Z company is a new company with little operating history that is focused on growth over profitability. The difference here from a Z company is that a pre-Z company hasn't gained enough scale to generate profits above its invested capital. I would consider Whole Foods (NASDAQ:WFMI) and FoxHollow Technologies (NASDAQ:FOXH) to be pre-Z companies.

Company Z
A Z company is profitable like a Y company but has more projects to invest in than it can fund from operating cash flows. While the company's ROIC is greater than its WACC, the company generates negative free cash flow and must use external sources for financing its growth. Knight Transportation (NYSE:KNX) is a Z company.

One reason I prefer Stewart's grading system over Lynch's categorization scheme is that it allows us to think more like business owners when allocating our own capital to an investment. We want our capital to generate returns, so we should allocate it to businesses that generate good returns as well. The kicker is always making sure you pay the best price possible. That's because successful investing is usually about getting the most bang for you buck.

Much of value investing is based on the concepts we've discussed here. So it shouldn't surprise you that AutoZone and CarMax are both Inside Value recommendations. Want to see who else has made the cut? All you have to do is take a free 30-day trial to see how Inside Valueis beating the market.

Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has a disclosure policy.