How to calculate lifetime value
A customer’s lifetime value (LTV) measures the total amount of revenue the customer brings to the business. To calculate LTV, companies must know how much customers spend, how often they purchase, how long they will remain a customer, and, for precision, the company's profit margin. Companies that don’t know their LTV can’t tell whether they lose money when acquiring new customers.
Why is lifetime value so important?
Lifetime value tells companies how much each customer is worth to the business. This, in turn, tells the company whether it makes money on each customer. Product, marketing, advertising, and sales teams can use LTV to calculate how much to spend on acquiring new customers, retaining existing customers, and their ROI on marketing campaigns and feature changes.
To calculate LTV, product teams must know several variables:
- Average order value (AOV): The average value of a customer transaction
- Purchase frequency: The average number of transactions a customer makes during a time span such as one year
- Customer lifespan: How long the business typically retains each customer
- Profit margin: The profit on customer transactions, expressed as a percentage
Customer lifespan calculations vary depending on how each company chooses to define them. For a SaaS accounting software that relies on fixed customer contracts, it may be obvious – a customer will simply fail to renew. But for a social media app, it’s much less so. The app’s team will have to draw a line and decide that customers with no activity after, say, eight weeks are considered to have churned.
The lifetime value (LTV) formula
There are several ways to calculate LTV. If the team behind an e-commerce store, for example, wants to know the total revenue each customer brings in over their lifespan, they can calculate Gross LTV.
If the e-commerce store team knows their AOV, how many times the average customer makes a purchase each year, and the average customer lifespan, they can use this equation:
Gross LTV formula:
AOV x purchase frequency x customer lifespan = Gross LTV
$50 x 10 times per year x 8-year lifespan = 4,000
Gross LTV = $4,000
The Gross LTV equation does not take into account the cost of acquiring the customer. There are expenses such as merchandising, warehousing, logistics, advertising, payroll, and more, which leave the company with only a percentage of profit. To get a better sense of the net value of each customer after factoring in these costs, teams can calculate Net LTV.
If the aforementioned e-commerce store team knows that its profit margin is 20 percent, it can either multiply the Gross LTV by 20 percent or use the following equation:
Net LTV formula:
(AOV x % profit margin) x purchase frequency x customer lifespan = Net LTV
(50 x 20%) x 10 times per year x 8-year lifespan = 800
Net LTV = $800
The Net LTV is typically much lower than the Gross LTV. It represents the actual profit left over after all other expenses.
LTV will vary drastically by vertical, business model, and even company. B2B companies with multi-year contracts have very different LTVs than e-commerce stores, consumer apps, or digital media publications. The most accurate way to track LTV is for each team to use its own past performance as a benchmark.
For deeper insight, calculate LTV by cohorts
An LTV calculation made across an entire customer database can be highly misleading. If half of an app’s users dislike the app and the other half love it, it doesn’t mean that the average user feels neutral. It means that app’s product team has two very different user cohorts that each require different treatment.
Companies can use cohort analytics to segment their customer bases into groups that share common behaviors. Teams can draw group distinctions based on whether they share a start date, geography, acquisition channel, age group, interest, or more. Often, each cohort has a different LTV.
Ticketmaster, for example, used Mixpanel to isolate its consumers and business clients and treat them separately. The Ticketmaster team was able to determine that its customers, for example, didn’t buy more tickets to events because they didn’t receive enough advance notice. By sending offers earlier, Ticketmaster’s team increased its consumer LTV. The team was also able to separate venues, artists, and promoters, and cater to those with the highest LTV within each group.
How can teams use LTV to limit their spending?
LTV is the maximum dollar value that companies can spend on acquiring and retaining customers and still make a profit. Once the customer acquisition cost (CAC) exceeds LTV, companies are spending more than they’re getting back.
Teams can also divide LTV by CAC to determine their ROI on customers. For example, if the LTV is $800 and the CAC $400, the ROI on customer acquisition is 200 percent.
Often, the math comparing CAC and LTV is imperfect. There are additional costs to retaining and keeping customers that product and marketing teams rarely take into consideration. For example, a retailer may spend money on discounts, promotions, and advertising for existing customers to drive additional purchases. These one-off costs are difficult to account for. As a rule of thumb, teams should be concerned anytime CAC rises anywhere near the level of LTV.
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