Customer lifetime value, also known as LTV, CLV, and CLTV, is an important financial instrument that estimates the revenue you are likely to generate from a customer during their lifetime of paying for a business's services. This metric is helpful in estimating customer profitability and creating boundaries to costs associated with acquiring new customers and growing the business. As a follow-up to my guide on CAC, I will walk through the simple LTV formula, considerations to think about with adapting the formula to your business, and the importance of keeping an eye on the LTV:CAC ratio. To start, let us take a look at the individual formulas that lead to the simplified customer lifetime value.
Average Purchase Value (APV)
= Total Purchases by Customers / Total Customers
This formula captures the average value of an individual’s purchase for a given time period and is helpful in understanding customer demand and price elasticity.
Average Purchase Frequency (APF)
= Total Orders / Total Customers
This formula indicates the average amount of times a customer purchases from you for a given time period. It helps give you a sense of customer purchasing patterns and is an important metric for gauging the performance of loyalty programs.
Average Customer Value (ACV)
= APV * APF
This formula indicates the average customer value for a given period of time.
Average Customer Lifespan (ACL)
= 1 / Average Monthly Churn Rate
This formula indicates the average lifetime of a customer in months. Churn rate measures the rate at which, customers terminate their service with a business for a given period of time. This rate is an important indicator of future revenue and growth. With the ACL formula, we convert this percentage to a unit value that represents the average amount of months a customer remains with the business.
Customer Lifetime Value (LTV / CLTV / CLV)
= ACV * ACL
By taking the average customer value and multiplying it by the average customer lifespan we now have a value that represents the amount of revenue generated by a customer for the lifetime of them paying for a business's services.
The formula above is a simplified version of calculating LTV and is commonly found when you search for how to calculate LTV. However, that doesn’t mean it is the only way to calculate it. Most businesses build on this formula to adapt it to unique elements of how their business operates. Here are a few variables to consider that can help improve the accuracy of your estimate.
Like any modeling, the larger the sample size, the more reliable the value can be. Traditionally LTV is formulated based on one year to three years' worth of data. The selection is rather arbitrarily selected and based on data availability and customer segmentation.
Segmentation / Cohorting
While an overall LTV provides practical value to a business, it overlooks the fact that not all customers are the same. Given the variables involved in generating the LTV it is easy to understand that every customer has distinct characteristics that can vary greatly from each other. For this reason, segmentation is an important consideration as a business because your goal is to grow and retain your most profitable customer segment.
One incorrect assumption about the customer in the simplified LTV formula above is that they will generate the same average amount of revenue per month for the duration specified. However, the future value of revenue is very likely to be less valuable than the present value. To account for risk and time value of money a discount rate should be applied to be more conservative with your assumptions. Typically the value used for this value is between 10% and 15%.
Projections can be helpful to include in the calculation of LTV for a variety of reasons like adjusting for future changes based on variables like churn, trend, and seasonality, as well as in situations where historical data is not reliable or you don’t have enough historical data. These examples just scrape the surface of how projections can be used to help improve LTV accuracy but should help seed some ideas for use within your own formula.
LTV / CAC
The measurement of LTV/CAC should not be overlooked. In my previous post on customer acquisition costs (CAC), I highlighted the importance of CAC in measuring the effectiveness of our acquisition media spend. When combined with LTV, the ratio provides us with the expected multiple the customer provides relative to the cost of acquiring the customer. The industry goal for this ratio is to be at least 3:1, meaning for every $1 you spend to acquire a customer, you generate $3 in return. This ratio shows the profitability and growth that investors want to see in a business because it provides high-growth companies with the runway to continue to support their growth (R&D, G&A, COGS) without cutting into their cash reserves.
Pulling it All Together
LTV is a crucial metric to track to understand the profitability of your customers and adjust your strategy to improve this value. The estimate is the output of the various variables related to customer revenue and gives you a simple business health indicator to follow, rather than having to compare and contrast various revenue metrics. This is not to say that you shouldn't scrutinize all revenue values, but that it is an easy metric for all departments to rally around without having to be bogged down in the numbers. Alone, the estimate is powerful but used as an input in ratios with other metrics it captures the impact individual parts of the business have on LTV. The more aware you are of LTV and how to use it to improve your strategy, the better your business will be.