Customer lifetime value can feel both intimidating and important. Let’s break down the common questions and dive in.
Growth Strategy Lead
What is the customer lifetime value (LTV)?
Customer lifetime value (LTV) is a business metric that attempts to capture how much a customer is worth over the course of their relationship with your business.
As an example, imagine your favorite local restaurant. Their LTV number would require a few inputs:
What is the average cost of a meal there?
How many times will you eat there, over your lifetime?
If it costs on average $50, and you have eaten there 10 times in the last two years. Your value to the restaurant so far is $500 (though it’s possible you’ll be worth more over your lifetime as a customer). If you average that number across all the restaurant's customers- you get the customer lifetime value (CLV).
But LTV is not always that simple. Differences in your product, customers, pricing and business model can make this a more complex calculation. Some businesses take into account fulfillment, marketing, and other costs, and may even calculate a profit per customer. But let's keep things simple for a minute.
Why does the customer lifetime value matter?
There are a number of reasons the CLV matters.
LTV can be used to determine if we are profitably acquiring new customers.
This tends to be the #1 reason. If the customer lifetime value is lower than the customer acquisition cost (CAC) then the business is losing money each time it gets a new user. If the lifetime value is much higher than the CAC, then we should consider increasing marketing spend. So this is critical, especially to Marketing.
LTV can be used to determine much to invest in re-marketing existing customers.
If a significant amount of revenue comes after the initial purchase, we need to develop a plan and budget to make sure we continue to capture all the additional lifetime value.
LTV is a key driver of revenue growth, and tracking it means we can improve it
If we can calculate and track the lifetime value, we can then develop hypotheses about how to increase it. Are we hoping to increase LTV by increasing frequency of purchase (like Amazon does) or by increasing the categories they shop with us (like Apple does where an iPhone leads to an Apple Watch, Airpods, or a new Mac) or increasing the length of time they do business with us (Netflix) Once we can calculate the LTV, we can start working on a plan to drive growth.
Why LTV can be hard to figure out
Typically, businesses will know how much a customer spent on every transaction they’ve had. But knowing what the expected lifetime of that customer might be, that’s the hard part.
Think back to the restaurant example earlier. So far, you may have been worth $500 to your favorite restaurant. But how much will you be worth in the future? How would my grocery store know if I started shopping at a competitor, or am just on vacation?
How do you calculate the lifetime value?
In general the LTV consists of two main components:
How many purchases a customer made in a specific time period
How much those purchases were worth
The most common business models we work with are
Subscription-based companies that have recurring products
So let’s use examples from these types of businesses, to show how they might calculate LTV.
How do you calculate the LTV for a subscription business?
For subscription businesses, it’s best to use cohort analysis to identify a group of customers who signed up in a time period, and then calculate each month afterwards.
Identify new signups for a specific month
For each month afterwards, identify how many of those customers remain active, how many churn, and how many previously churned customers reactivate their account.
Do the same things for multiple months, and identify the trend
Cohort charts are often useful to visualize the results.
Caveat: The churn in the first month is typically much higher than subsequent months. Why is that? Many of the people who cancel in the first month may not be your ideal customers, or may have ordered by accident, or never got value from the product. If you can, use two churn rates, one for the initial period, and another for subsequent periods.
If you happen to know your average churn rate, it will be straightforward to calculate the LTV of your subscription business.
As an example, imagine your MRR is $9.99 and about 5% of customers churn every month:
LTV = $9.99 ÷ 0.05
LTV = $199.80
With a churn rate of 5%, your customer LTV will be about $199.80, and customers will be active for about 20 months on average.
How do you calculate the LTV for an online retailer?
For ecommerce retailers it can be more difficult to know if a customer is still active and may make additional purchases in the future. That’s why most models for ecommerce use probabilities to estimate how likely it is that we will get additional purchases from our customers.
If having a specific LTV is very important to your business, you can develop a “buy till you die” model which uses all of our purchase data to create a probability and estimated monetary value for each customer.
This would require some data science work, and might take more time and energy than you need at this point.
So here is a simplified approach which should work for most people. Simply take the all the transactions you’ve received from 24 to 12 months ago, and find all the unique purchasers who placed a their first transaction in that time. That is the number of unique new purchasers.
Then we look at all the sum of all transactions those users placed in the last 24 months and divide by the number of uniquer purchasers. That is the Total value from those purchaser. Divide one by the other them to get your customer LTV.
LTV = Total value from those purchasers / number of purchasers
We look 12 month back because we want to see how many of them will come back and place a purchase down the road. Keep in mind that every business will have a different payback period for their marketing, and a different customer lifecycle. If your business is new, start by looking at a 90-day LTV period in order to keep the calculation realistic.
When is customer lifetime value not important?
There are some businesses where the natural reorder rate will be very low, and the time between re-orders may be long. If your business fits into that model, you’ll want to make sure that the initial sale to a new customer is profitable and that CAC is lower than AOV for each channel.
One example might be something like a mattress which you might replace every 5-10 years.
What are the dangers of lifetime value?
Things can change
Businesses can get in trouble if their customer lifetime value has changed and they continue to rely on older figures. This can be common when the mix of marketing sources changes or the business scales.
Imagine a business which started with a lot of word of mouth, and that led to a lot of customer loyalty and a higher LTV. What would happen if, later, the business started a pay-per-install advertising campaign? Customers might churn more quickly, leading to a lower LTV.
Average customers aren’t average
In some cases, the LTV can be skewed by a few customers who are extraordinarily valuable. We have worked with clients where less than 5% of their customers generated more than 70% of revenue. In that case, an average customer LTV is not as helpful.
Instead, it can be useful to segment your users and find a LTV for the high-value segment, and the rest of the customers separately.
If you want to read more about the dangers of LTV, Bill Gurley has posted a detailed walkthrough on his Above the Crowd blog.
How do we think about lifetime value across marketing channels?
Often a business will see different traffic sources result in different LTV.
For example, customers who came from the paid search campaign, where the keywords were related to the brand name of the company, are likely to have a clear idea of the product and understand the value. For that reason, visitors from paid search who used brand keywords will tend to have a high lifetime value.
On the other hand, “display” traffic might have a lower interest in the product, and worse retention rates.
When first launching a product, it is reasonable to stick with an overall LTV. But once you’re spending a significant amount of money on any type of paid advertising, it can be useful to check that LTV of your paid channels is matching your expectations.
How does LTV fit into our overall revenue model?
LTV is probably the most important component of your revenue model. From a high level, your revenue is:
How many people came to your site
How many converted to customers
What are those customers worth
How many people came to your site [Traffic volume]
How much traffic you are getting is a trailing metric. If you are converting well, and have a high LTV, you can develop marketing channels to drive traffic. Of course if you have zero or very little traffic, you need to get some in order to get feedback from real customers and see if you are close to product-market fit.
How many converted to customers [Conversion rate]
The conversion rate of how many people who come to your site to become customers tends to be the first focus. It can tell you: is my messaging clear, do prospective customers understand how we are unique, is the user experience good. It is a good first thing to focus if your business is new. But once you have a reasonable number of customers, the LTV becomes the most important. A high conversion rate doesn’t matter if the new customers aren’t sticking around.
What are those customers worth [Lifetime value]
If your LTV is high, you will be able to use paid channels to grow your business. Businesses with lower LTV (less than $100 per customer) are often not able to profitably acquire users via Facebook, Instagram, Youtube, Google.
How do we know what time period to consider for our customer lifetime value?
There are a few things to consider when determining how long to consider your lifetime value window.
If you are a new business- keep it short.
You are more likely to be working on making sure you have product-market fit, and are getting customer feedback.
Lifetime value is a vital metric that you can use to track and measure the health of your business. But even though it may be easy to get a baseline LTV number from a few simple datapoints, there are plenty of deeper complexities when it comes to understanding how LTV changes over time, and how it can be useful for marketing departments in their day-to-day work of delivering campaigns and optimizing spend.