Why optimizing returns builds more wealth than maximizing them

Business leaders, entrepreneurs, and business investors tend to obsess over maximization.

Maximum margins. Maximum leverage. Maximum short-term cash flow.

‍Maximum returns.

‍

Seems sensible, doesn’t it? On the surface, yes. After all, higher returns should lead to more wealth. Unfortunately, this instinct often produces the very opposite outcome. So if the goal is not to maximize, what is it?

‍The goal is to optimize returns.

The distinction is one of the most important differences between businesses that remain small and those that compound to turn owners into extraordinary wealth creators.

The trap of maximum returns

Founders who focus exclusively on maximizing current returns tend to design businesses that are too narrow in scope, too fragile in downturns, and too constrained to scale. This is why some smaller businesses can generate eye-catching pre-tax equity returns but never actually create real wealth for their owners.

‍In this article, I illustrated this point with a hypothetical restaurant business. 

Here’s a quick recap of the math

Assume the following:

$3M Business Investment

$2.25M OPM Funding (75%) + $750k in equity (25%)

8% Cost of OPM Annually

$5M Annual Sales

20% Operating Profit Margin

$150k Annual Maintenance Capital Expense

Then plug it into this equation:

(Sales ÷ Business Investment x Operating Profit Margin) - (OPM x OPM Cost) - (Annual Maintenance CapEx  ÷ Business Investment) ÷ (1- OPM/Business Investment)

Which looks like this:

($5M ÷ $3M x 20%) - (75% x 8%) - ($150k  ÷ 3%)  ÷ (1 - 0.75) = 0.8932

For a current pre-tax equity rate of return of 89.32%

‍

If you compare the current pre-tax equity return I calculated there of roughly 89% to Apple’s approximately 60% current equity creation yield in 2024, it looks like the restaurant is the clear winner. Yet the restaurant can never address a market remote close to the size of Apple’s market.

As a result, only a handful of the wealthiest Americans owe their fortunes to the restaurant industry, while technology-enabled business models dominate the upper tiers of wealth creation. Maximization produces a great number, where optimization produces a great outcome.

Optimizing returns for total wealth, not peak yield 

As you can clearly see, optimal returns are those that create the most wealth, not the highest percentage in isolation. Optimized business models are designed to deploy capital repeatedly, scale without collapsing margins, preserve flexibility under stress, and maintain a margin for error.

This is why a business with a lower current return can ultimately create far more wealth than one with a higher return that cannot grow, reinvest, or survive volatility. As we discovered when previously discussing Current Cash Yield, high current yields matter because they enable growth. Optimization is how you ensure that growth does not destroy the model that made those yields possible in the first place.

Leaders decide optimization (not spreadsheets)

I truly believe business model design is an art. That’s why spreadsheets can show you what’s possible, but it takes a true business leader to decide which strategies to apply.

‍

Optimizing returns requires judgments, including:

How much equity is truly necessary?

How much Other People’s Money can the business safely carry?

How much margin for error is enough?

How much reinvestment is required to protect the franchise?

‍

As the Six Variables of The Value Equation aim to make clear, capital efficiency, operating efficiency, and asset efficiency must work together. Pushing any one of them too far in pursuit of maximum returns can destabilize the entire system. The thing to remember is that optimized businesses rarely look dramatic in their early years because it’s not about squeezing every last dollar out of the business as it stands today.

‍

The point of designing an optimized business is to:

• Generate strong cash yields
• Reinvest cash yields productively
• Earn higher valuation multiples
• Raise new capital at attractive prices
• Compound cash flow per share over time

‍

Over time, optimized businesses become worth far more than what they cost to create. 

That’s the true objective of business design.

And it is where The Value Equation ultimately leads you.

My YouTube Channel explores these concepts visually – join us and learn what you need to know to become business rich.

‍