You have to spend money to make money, or so goes the old adage. Running a business today takes serious capital - no longer can you fake it with just ingenuity and creativity. However, that doesn't mean a business can't spend efficiently. In fact, those are the businesses to look for when investing: companies that know how to spend their hard-earned dollars, squeezing out every penny.

IN PICTURES: 9 Simple Investing Ratios You Need To Know

A calculation to use in order to examine similar businesses and their ability to handle cash is a derivative of both free cash flow and return on equity. Take the most recent trailing 12-months figure for EBITDA (Earnings before interest, taxes, depreciation and amortization), and subtract the most recent annual capital expenditures (CAPEX) and then divide that number into shareholder equity. It looks like this:

EBITDA (TTM) - CAPEX (Annual) / Shareholder Equity (Annual)

This calculation simultaneously allows us to understand how much a company spends to make each dollar of EBITDA and the return it provides shareholders. It's not terribly scientific, but when used with similar businesses, it's quite effective at pointing out the efficient ones.

Specialty Retail Industry
Company EBITDA (TTM) CAPEX (Annual) Shareholder Equity (Annual) CAPEX Per $1 EBITDA Return (%)
Staples (Nasdaq:SPLS) $2,130,000,000 $313,228,000 $6,771,886,000 0.15 26.8%
Luxottica Group (NYSE:LUX) $1,300,000,000 $276,126,000 $4,022,130,000 0.21 25.5%
Sherwin-Williams (NYSE:SHW) $918,710,000 $91,328,000 $1,490,950,000 0.10 55.5%
Pet Smart (Nasdaq:PETM) $638,060,000 $112,920,000 $1,172,715,000 0.18 44.8%
Tractor Supply Company (Nasdaq:TSCO) $316,570,000 $73,974,000 $733,203,000 0.23 33.1%

Specialty Retail Breakdown
For every dime in capital expenditures, Sherwin-Williams makes $1 in EBITDA, generating a modified return on equity of 55.5%. Its CAPEX-to-EBITDA ratio and return on equity are superior to the other four companies in the table. This doesn't necessarily mean its the best stock, but it's definitely a good start. In terms of the P/E ratio, with the exception of Luxottica Group, they're all within three percentage points of each other, so there's no real differential in valuation.

In terms of profitability, the next best is PetSmart, which spends 18 cents in capital improvements to generate $1 in EBITDA. Most importantly, its modified return on equity is second highest at 44.8%. There's a lot to like about the company including a second quarter where earnings per share grew by 32%, same-store sales were up 4.6% and operating margins improved by 210 basis points. There's really no weakness in this growth and income play and as such, it's the best of the bunch. The next best is Tractor Supply, which continues to grow earnings at an impressive clip, up 46% in the third quarter. While Sherwin-Williams looks good as a company, I just don't think it has the earnings growth potential that Tractor Supply does.

Apparel Stores Industry
Company EBITDA (TTM) CAPEX (Annual) Shareholder Equity (Annual) CAPEX Per $1 EBITDA Return (%)
DSW (NYSE:DSW) $203,150,000 $23,080,000 $524,881,000 0.11 34.3%
The Men\'s Wearhouse (NYSE:MW) $184,100,000 $56,912,000 $902,344,000 0.31 14.1%
Buckle (NYSE:BKE) $225,380,000 $50,561,000 $354,259,000 0.22 49.3%
Ann Taylor Stores (NYSE:ANN) $193,210,000 $38,573,000 $417,186,000 0.20 37.1%
Jos. A Bank Clothiers (Nasdaq:JOSB) $156,180,000 $16,333,000 $393,310,000 0.10 35.6%

Apparel Stores Breakdown
My two picks - Buckle and Jos. A Bank - are straightforward. Buckle is efficient in everything it does. It's a master at allocating free cash, whether it be for capital expenditures to expand its store network across the country, to repurchase shares or to pay special dividends to shareholders. In most situations, it appears to consider the interests of all shareholders and not just the interests of Chairman Dan Hirschfeld, who owns 36% of its stock.

I can think of three specific instances. The first involves store expansion. Despite lacking a presence in a number of Northeastern states, it's expanding at a steady rate of 20 stores annually, which pales in comparison to competitors Urban Outfitters and Aeropostale. It could easily double the number of store openings, but it chooses a more conservative financial and operational approach that works. Excess cash is returned to shareholders using the rare share repurchase when the stock is cheap, through an annual dividend that is currently 80 cents a share and since 2006, three special dividends totaling $5.13 a share. Much of this money could go toward store expansion but that wouldn't necessarily be what's best for shareholders.

The other pick is Jos. A Bank, a company that continues to generate consistent profits and revenue growth. In the past decade, the Maryland-based menswear chain has increased revenues and net income every year. You can't get any better than that. Add to this the fact it only spends 10 cents to generate $1 in EBITDA and you have a winner on your hands. (Financial discipline is the key to successful growth in the retail industry. To learn more, see The 4 R's Of Investing In Retail.)

The Bottom Line
Companies that spend wisely usually do well financially because they understand how hard it was to earn the money in the first place, and those companies, for some investors, are the most beneficial to own.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  3. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  4. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  5. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  6. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  7. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  8. Stock Analysis

    Top 3 Stocks for the Coming Holiday Season

    If you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
  9. Investing News

    Could a Rate Hike Send Stocks Higher?

    A rate hike would certainly alter the investment scene, but would it be for the better or worse?
  10. Investing News

    Corporate Bonds or Stocks: Which is Better Now?

    With market volatility high, you may think it is time to run for corporate bonds instead of stocks. Before you do take a deeper look into which is better.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!