Capital Allocation

"My one subject," wrote Warren Buffett, Berkshire Hathaway's(NYSE: BRK.A) legendary chairman in one of his equally legendary letters to stockholders, "is capital allocation."

Whether they'll admit it or not, capital allocation is in fact every corporate executive's primary subject. Whether they choose to treat it thus is another story, as some seem instead to focus undue amounts of energy on such ancillary matters as buttering up Wall Street analysts, pleasing stockholders with such window-dressing moves as stock splits, or being interviewed and photographed for flashy magazines.

That's why at the end of the day/quarter/fiscal year, perhaps the most important measure of management's effectiveness is the way in which it allocates capital -- and the returns generated by that allocation. (The Rule Breaker team wrote a good take evaluating the allocation acumen of eBay's(Nasdaq: EBAY) management, along with several other top companies.)

Thankfully, there are good, solid, numerical measures for this. In fact, pretty much any measure of a company's performance -- from revenues to profit margins to same-store sales to free cash flow -- can help paint this picture.

But we think some are better than others. Four are return on invested capital (ROIC), return on marginal invested capital (ROMIC), retained earnings, and the Foolish Flow Ratio. Investors may want to examine top managers' track records in improving these and other metrics at their current and former companies. 

Return on Invested Capital
A favorite number of Fools who enjoy digging into their companies' numbers -- and those who don't particularly enjoy it, but do it anyway -- is ROIC.

Though it's somewhat more difficult to calculate than simpler numbers like return on assets (ROA) or return on equity (ROE), which can both be generated simply by plucking numbers from financial statements, ROIC is nevertheless a superior gauge of performance because it improves upon figures such as earnings, which are largely byproducts of accounting and thus questionably useful as gauges of operating performance.

Rather than get into "how to" here, I'll direct you toward Andrew Chan's handy explanation of calculating ROIC. While there is no hard and fast number investors should expect, one might look for a figure in excess of the S&P 500's 11% historical return -- and an upward trend is, obviously, preferable. 

Advanced investors can take things even further. By identifying the difference, or "spread," between a company's ROIC and its weighted average cost of capital (WACC) an investor can determine how much value a company is creating (or destroying) for every dollar that is invested in the business.

But WACC can admittedly be difficult to calculate as you get into cost of equity and other factors. I wouldn't say "don't bother" -- not by a stretch -- but it's not something that's easily generated.

Return on Marginal Invested Capital
ROMIC takes ROIC one step further, as it focuses on the returns generated by the most recent capital invested in the business. The number is generated in much the same way as ROIC -- in short, by dividing a period's net operating profit after tax by its invested capital for that same period -- but counts only the amount by which those figures increased year-over-year.

Bob Fredeen suggested that by tracking ROMIC trends an investor may be able to foretell coming decreases in ROIC if a company is generating decreasing returns, even as it invests more and more capital into its business.

Retained Earnings
Retained earnings is a balance sheet line item that measures earnings not paid out to shareholders in the form of dividends or stock buybacks or used for acquisitions, which can thus be reinvested in the company's business or used to pay off debt. Ideally, a company's retained earnings increases steadily over time.

You'd like a company's market value to increase at the same rate or better, suggesting that each dollar invested by the company has turned into market value at or above a one-to-one ratio.

The Foolish Flow Ratio
Another favorite of our Rule Maker investors, though it's useful for all, the Foolish Flow Ratio is a measure of how efficiently a company manages the cash that (hopefully) flows through it.

Generally speaking, we want companies to collect from creditors as quickly as possible -- naturally -- while taking as long as possible to pay its bills (because that money, if held, can hopefully be used to generate a better return for our company than if it were simply dropped in an envelope and sent to another company). Managements that can establish business relationships that allow them to do this deserve kudos for doing so, and those that can't -- well, poor working capital management is another reason the Rule Breaker team passed on Lernout & Hauspie.

We measure this with the Flow Ratio. It's explained very nicely in our Rule Maker area, but the shorthand for it is this: (current assets minus cash & equivalents)/(current liabilities minus short-term debt).

We hope to see a number of 1.25 or lower -- below 1 is ideal, since that means the company delays more payments than it carries in costs of inventory and unpaid bills -- and a trend toward a lower "Flowie" over time.

Next: Management Focus »

Dave Marino-Nachison's (TMF Braden) stock holdings can be viewed online. The Motley Fool has  a full disclosure policy.