Customer Lifetime Value is one of the most important metrics a marketer should know

Your startup spends $2 to bring in a new customer. Is it worth it to spend so much to maintain a customer?

Customer Lifetime Value (LTV) helps you find that answer. Your first instinct would be to understand how much revenue that customer will be generating. That’s a good starting point. From there you should find out your average LTV. To do that, you’d also want to understand for how long the customer is likely to purchase from you. That is where things start getting complicated.

(You might also prefer considering margin over revenue. You can use the present value calculation for future cash flows.)

Let’s take a few steps back. LTV can be a complicated model. We’ll start from the basics.

What is Customer Lifetime Value (LTV)

Customer Lifetime Value is the estimated total revenue/profit a business can expect from a customer throughout their business relationship.

In simple terms, if your customer pays you $100 per year and stops purchasing from you after 10 years, LTV is $100 X 10 = $1000.

In the real world, understanding the length of your contract with a customer is the tricky part. There are ways to skip that and use customer churn instead.

LTV Formulas — Basic, With Profit & Traditional

Before we get to the LTV formula, let us get acquainted with a few marketing metrics. These will help us understand LTV better.

ARPU stands for Average Revenue Per User. The following example will further clarify how they work —

• Your total revenue in Year 1 is $1,000
• The total number of customers in Year 0 is 100
• 80 of those Year 0 customers also purchased in Year 1
• The total number of customers in Year 1 is 200

ARPU for Year 1 = $1,000 / 200 = $5

Retention rate = 80 / 100 = 80%

Churn = 1–80% = 20%

Basic Customer Lifetime Value (LTV) Formula

Customer Lifetime Value can be calculated using multiple formulas. The first two are:

Basic LTV Formula | Image by Author Mofrad Muntasir

Using the first formula, your LTV will be = $5/20% = $25

For the second formula, you will need to know for how long a consumer will stay with your company. To understand that, you need to —

• Have a longstanding business where you have years of data
• Or, check how customers behave in your industry
• Or, extrapolate customer behavior based on the data you already have.

LTV Formula with profit margin

While revenue is good, you might want to check how much profit a customer is going to bring. To do that, you need to multiply the Basic LTV with your profit margin.

If your profit margin is 20%, you have to multiply your Basic LTV with that 20% to get the LTV with profit margin.

In the previous calculation, we calculated that your LTV was $25. So, your LTV with profit margin would be = $25 X 20% = $5

Traditional LTV formula

The traditional LTV formula considers the rate of discount. The rate of discount is the interest rate you’d use in a discounted cash flow. This formula also uses the Average Gross Margin Per User — which is LTV with profit margin. The formula looks like this —

Based on the previous calculation, your Average Gross Margin Per Customer is $5. Your rate of retention is 80%. Let’s assume rate of discount is 10%. Your LTV (Traditional) is = $5 X ( 80% / 1 + 10% -80%) = $13.33

How to use LTV

Step 01: Compare with CAC

Customer Acquisition Cost (CAC) shows how much you need to spend to bring a new customer. LTV (with profit) to CAC ratio should be at least 3. If it’s lower than 3, your business might be in trouble.

Your business should look at LTV, CAC, and the ratio every month.

Step 02: Improve LTV

The second step is going to be a continuous process. If we consider the traditional formula, you need to do the following to improve LTV

• Increase Average Revenue Per User: There can be many ways to increase ARPU. You can upsell, cross-sell, and down-sell to your consumers. You can ask them to purchase more frequently. Or you can increase the price or introduce different levels of pricing. Sometimes even making the checkout faster & easier can increase your revenue.
• Decrease Churn Rate: You should run retargeting campaigns to bring back existing users. For that, your business can offer limited-time discounts, freebies, etc. so that they purchase regularly.

• Improve Profit Margin: To improve profit margin, you can look for ways to cut costs. It can be in the cost of goods sold, manpower, operations, or anything else.

Final thoughts on Customer Lifetime Value

LTV is one of the most important marketing metrics. If you can maintain a healthy ratio of LTV and CAC, your business will get to a good stage in no time.

This article was first published on Medium.