What Is Customer Lifetime Value (LTV): How To Calculate It?
Learn the meaning of LTV, how to calculate it, and how it impacts your company's financial results.
By Pipe September 21, 2023
Getting new customers on board is definitely exciting. But you know what's equally important? Keeping those customers coming back for more! We're talking about building a loyal following, where people keep choosing your products or services because they genuinely love what you offer.
Without that kind of customer loyalty, you'll find yourself stuck in a never-ending cycle of gaining and losing customers. Sadly, studies have shown that the cost of acquiring a new customer can be up to five times higher than maintaining the loyalty of an existing customer.
You need repeat customers to generate enough revenue to make acquiring them worthwhile. That's where customer lifetime value (LTV) comes into play. LTV helps you understand the value of each customer and determine their profitability.
Before we jump into the calculation, let's break down some key terms so we’re all on the same page:
Customer lifetime value (LTV, CLTV, or CLV)
This is the total amount of money you can expect customers to spend on your products or services over time.
Customer acquisition cost (CAC)
CAC shows how much you spend, on average, to bring in each new customer.
This handy metric shows you how much value you get from each customer compared to what you spend to acquire them. Basically, it sheds light on the profitability of your customer base over time.
Gives you an overview of your past customer LTV based on previous data. By looking at past data, you can gain insights into the LTV of your customers and understand their value over time.
This helps you forecast the potential value you'll receive from future customers, empowering you to make informed decisions.
What is customer lifetime value (LTV)?
Customer lifetime value, often abbreviated as CLV or LTV, is an important financial metric that measures the total amount of money you can expect to receive from each customer over the duration of your relationship with them.
It’s beyond simply looking at how much it costs to acquire a customer or their initial purchase. LTV provides a holistic view of the value derived from the customer relationship, helping you assess whether your customer acquisition cost (CAC) is justified.
In essence, it quantifies the long-term value of each customer to your business.
How do you calculate LTV?
The customer lifetime value formula will reveal to you how much the average client is worth to your business over the duration of the relationship. It’s often calculated as:
Customer lifetime value (LTV) = Customer value (CV) x Average customer lifespan (ACL)
Where: CV = (Average purchase value) x (Purchase frequency); and
ACL = Total of all customer lifespans ÷ by the total # of customers
Basically, here’s a quick rundown on what you need to do when trying to calculate your LTV:
Step 1 (Determine the time period for analysis): First, establish the timeframe you want to consider when calculating LTV. It can be based on months, years, or any other relevant duration.
Step 2 (Gather data): Collect the necessary data to perform the calculation. This includes:
Average Purchase Value (APV): Calculate the average amount a customer spends per purchase within the chosen time period. This is achieved by dividing the total revenue generated from a customer by the number of purchases made over the specified timeframe. This provides insight into how much, on average, a customer spends per purchase.
Purchase Frequency (PF): Determine how often, on average, a customer makes a purchase within the chosen time period. This is achieved by dividing the total number of purchases made by the number of unique customers over the specified timeframe.
Average customer lifespan (ACL): Estimate the average duration of a customer's relationship with your business. To calculate the customer lifespan, add all of your customer lifespans and divide by the total number of customers. It can be measured from the first purchase to the last purchase or from the start of the relationship to churn.
Step 3 (Calculate customer lifetime value): Using numbers from step 2, multiply the average purchase value by the purchase frequency and then multiply that result by the customer lifespan.
LTV= (Average Purchase Value) x (Purchase Frequency) x (Customer Lifespan)
Suppose a customer has an average purchase value of $100, makes four purchases per year, and remains a customer for five years. Using the formula:
LTV= $100 (average purchase value) x 4 (purchase frequency) x 5 (customer lifespan)
LTV= $2,000 (In this scenario, the customer lifetime value would be $2,000).
By calculating your LTV correctly, you gain insights into the revenue potential of each customer and can make informed decisions regarding customer acquisition and retention strategies.
Why should you care about customer lifetime value (LTV) and its impact on your business?
So, the question is, what value does LTV bring to your business? Here are a few insights you can glean from a customer lifetime value calculator.
LTV provides insights into the profitability of your customer base. It helps you identify the most profitable customers and segments, enabling you to allocate your resources effectively. It can also help you identify whether your acquisition strategies are sustainable.
This insight can guide decisions regarding marketing channels, pricing strategies, and customer acquisition investments. It can also help you focus on attracting customers who are likely to have higher LTV rather than simply chasing quantity.
By understanding which customers generate the highest lifetime value, you can focus your marketing efforts, cross-selling, and upselling initiatives on them, increasing revenue and profitability. This way, you can prioritize your efforts and provide personalized experiences to different customer segments.
Targeted marketing and personalization
By focusing your efforts on your ideal customer group, you can fine-tune your marketing strategies, tailor your messaging, and optimize your product or service offerings to cater specifically to their needs. This helps you target the right audience, personalize your marketing messages, and attract customers who are more likely to become loyal advocates.
This approach ensures that you are investing your marketing budget wisely, attracting high-value customers, and maximizing revenue potential by reducing costs on customers likely to spend less over time.
Improved customer retention
LTV is closely linked to customer retention. Identifying high-LTV customers allows you to prioritize their satisfaction, build strong relationships, and implement retention strategies. By delivering exceptional customer experiences, you can increase loyalty and reduce churn, ultimately driving revenue growth.
By focusing on customer satisfaction, providing excellent service, and fostering loyalty, you can increase LTV. Happy, loyal customers tend to spend more, refer others to your business, and become brand ambassadors, contributing to your growth organically.
Business model viability
Onboarding a lot of customers is great—but it doesn’t mean your business can survive in the long term. If your average customer isn't bringing in enough value, you could end up burning through your financial resources and finding yourself in a tight spot—running out of cash or scrambling to secure more funding.
Here's where understanding your LTV comes into play. It gives you valuable insights into the overall viability of your current business model. Think of it as a reality check, helping you gauge when it's time to call it quits or redirect your company's focus towards more profitable products and services.
Segmenting product categories
Your customer LTV does a great job of giving you a big picture of your company's overall financial health, but you can also narrow your focus and look at the LTV for specific product categories.
You may have categories that are more profitable than others. By focusing on these product categories, you can scale your customer acquisition campaigns with less risk to generate more sales for your business.
Find new opportunities
LTV not only helps you identify the most lucrative product categories but also presents an opportunity to explore and create companion products that complement these offerings. By doing so, you increase both your average order value and LTV over time.
Creating companion products enables you to offer bundled or related items, encouraging customers to increase their overall purchase value and engage with a broader range of your offerings. This strategy not only boosts your average order value but also strengthens customer loyalty, further increasing lifetime value.
By continuously exploring and innovating in this manner, you can uncover new opportunities within your product lineup, expand customer engagement, and ultimately drive sustainable revenue growth.
Customer lifetime value models
When assessing your LTV, there are two models you can consider to measure the value of your customers during the relationship: historical and predictive analysis. Let's take a closer look at both.
Historical LTV model
This model analyzes historical customer data to make accurate predictions about their value. It involves analyzing past customer behavior and using that information to create a snapshot of their value at a specific point in time.
This model is useful for businesses that have a stable customer base and can rely on historical data to make accurate predictions about customer value. It provides a more conservative approach to estimating customer value, as it does not rely on potential future behavior but rather historical trends.
However, it's important to note that obtaining a complete picture of LTV through historical analysis can require years of data, which young companies may not have.
Predictive LTV model
On the other hand, predictive LTV focuses on predicting future customer behavior based on current and past customer data, allowing you to gain a clear understanding of your potential future profitability. This is particularly useful for business models with recurring revenue–such as D2C subscription businesses and SaaS companies.
Since revenue stays fairly consistent from month to month with these business models, predictive LTV helps companies get an accurate picture of their future profitability so they can use that knowledge to make more informed decisions.
This approach is useful when you want to make forward-looking decisions and create “what-if” scenarios to see the potential outcome of various decisions.
Choosing between these models depends on your specific business goals and the context in which you operate. Here are some factors to consider when deciding:
Time horizon: If you are more concerned about long-term customer value and want to anticipate future behavior, the predictive model is a better choice. It considers the evolving customer landscape and adapts to changing trends.
Stability of customer behavior: If your business experiences relatively stable customer behavior and the historical data is reliable, the historical model can provide accurate predictions without relying on uncertain future behavior.
Resource constraints: Implementing a predictive model requires access to real-time and comprehensive customer data, as well as the computational resources to perform the analysis. If you lack the necessary data infrastructure or have limited resources, the historical model might be more feasible.
Risk tolerance: The predictive model involves some degree of uncertainty since it relies on future predictions. If you prefer a more conservative and risk-averse approach, the historical model, which relies on past performance, might be a safer choice.
By considering both historical and predictive LTV, you can paint a comprehensive picture of your business's performance, drawing from past achievements while embracing future opportunities. This knowledge serves as a solid foundation for strategic decision-making and maximizing the long-term value of your customer relationships.
Lifetime value and customer acquisition cost
Understanding the relationship between Lifetime Value (LTV) and Customer Acquisition Cost (CAC) is crucial for the financial success of your business.
If the cost you incur to acquire customers exceeds the average amount a customer spends over their lifetime, you’ll never be able to achieve profitability. In such cases, it becomes essential to reduce your customer acquisition cost or increase the amount customers spend over time.
Conversely, if your acquisition cost is lower than the average customer spend, you can confidently invest in ramping up your marketing efforts, knowing that it will yield a positive return on investment. The higher your LTV compared to your CAC, the faster your company can experience growth.
To boost customer lifetime value, focus on delivering exceptional experiences, personalized offerings, and effective retention strategies. This encourages repeat purchases, referrals, and brand loyalty, ultimately increasing their overall value. As a rule of thumb, the higher the LTV:CAC ratio, the faster you can grow your business. Now let’s learn how to calculate the LTV:CAC ratio.
Understanding the LTV: CAC calculation
Evaluating the relationship between Lifetime Value (LTV) and Customer Acquisition Cost (CAC) allows you to assess the profitability and sustainability of your business model. The LTV:CAC ratio formula provides a quick way to do so.
To determine the LTV:CAC ratio, you divide the LTV by the CAC. A higher ratio signifies a better return on your investment in acquiring customers.
To calculate your CAC, divide your total acquisition expenses by the number of customers obtained:
CAC = Sales and Marketing Expenses / Number of Customers Obtained
Once you have determined your CAC, you can calculate your LTV:CAC ratio:
LTV:CAC ratio = LTV / CAC
The commonly accepted standard for a "good" LTV to CAC ratio is 3:1. This means that your average customer should generate at least three times as much revenue as the cost incurred to acquire that customer. Keep in mind, this can vary by industry.
However, it's important to note that an excessively high LTV:CAC ratio may not always be desirable.
In this case, your LTV is strong enough to warrant increasing your CAC to drive more growth. By experimenting with adjacent products and launching targeted marketing campaigns in those areas, you can temporarily reduce your LTV:CAC ratio and enhance overall profitability. This approach enables you to uncover new growth opportunities, expand your customer base, and drive the overall success of your company.
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