How to calculate LTV within your company?

Customer Lifetime Value (CLV or CLTV) is the term used to define a forecast of the amount of money the company expects to receive from a customer for as long as the customer remains a customer.

Many companies make a digital marketing plan and add the Life-time value calculation to discover the profitability of their business, as it helps them to obtain accurate data on how much profit they get for each of their customers and contrast it with the efforts made to acquire them.

LTV is therefore an extremely important KPI for a business, as the probability of selling to a potential customer is usually between 5% and 20%, while this percentage rises to 60-70% when it comes to selling to a customer who has already bought once (this could vary depending on the industry).

Taking into account the above, we can say that the Cost per Customer Acquisition (CAC) should be lower than the lifetime value (LTV), since the idea of companies is that it costs less to acquire a customer than what they get from him.

How to calculate the LTV correctly?

There are several formulas to calculate the LTV. Depending on the number of variables you measure and as long as you want to obtain more data, the formula can become complex. However, the simplest one is the following:

Information:

Average value of purchases (average ticket): To calculate this number, you must divide your company's total revenue for a period of time (usually a year) by the number of purchases recorded during that same period of time.

Average purchase frequency index: to calculate this value, divide the number of purchases recorded during the established period by the number of customers who made purchases in that same time.

Average customer lifespan: To calculate this value, average the number of years that the customer continues to purchase the products or services you offer.

With the above formula, you can get an initial estimate, but it does not consider the cost you assume to deliver your product or service.

If you want a more accurate estimate, you should include the contribution margin in the formula for the average customer lifetime value. A company's contribution margin, over some time, can be calculated as the difference between sales volume and variable costs.

Calculating LTV with contribution margin

This calculation should give a more conservative LTV, and is a better guide for making business decisions.

By going deeper and deeper into the procedure, the following two variables can be included in the formula for calculating the LTV:

Customer retention rate.

This refers to a company's ability to retain its customers over a given period. If this rate is high, it means that the company has loyal customers who return and continue to buy.

This variable allows you to incorporate into the calculation the fact that some customers will not stay with you for 10 years. They will probably stop being your customers before that time due to multiple reasons.

On the other hand, you may also have heard about the churn rate. It means that, when you have a retention rate of 75%, the churn rate is the remaining 25%. This percentage represents the customers who do not have 10 years with you.

To calculate it, you have to determine the period you are going to focus on week, month, quarter, or year. Whatever your choice, you need to obtain the following information:

S: The number of customers that exist at the beginning of the period.

E: The number of customers you have obtained at the end of the period.

A: The number of customers you have gained during the period.

To calculate the percentage of customer loss, you must subtract the number of customers you gained at the end of the period (E) and the number of new customers you gained (A). Then divide by the number of customers you had at the beginning of the period (S) and multiply by 100.

Discount rate

The discount rate or "cost of capital" is the rate applied to identify the present value of a payment to be received in the future. In other words, how much is a payment that will be received in a year worth today, for example? Such a consideration becomes necessary as the value of money changes over time.

The discount rate is the inverse of the interest rate because while interest is to add value to future money, the cost of capital is to "discount" value to that amount of money, to determine its real value for today's date.

Understanding the concept of present value is very important for your customer's lifetime value projections, as it allows you to identify the present value of the cash flow that the customer will be contributing to you throughout his life as a buyer.

LTV calculation with retention rate and discount rate

To calculate the LTV with both rates explained above, first, you have to know which discount rate you are going to use. There are several ways to find out:

If the company has a finance department, you can directly check what discount rate or cost of capital they maintain. This value should already be specified; since, normally, the historical return that the company has had is used.

If you have a small business, take as a reference the interest rate that your bank offers you when placing a fixed-term deposit for 1 year.

With this, you will have all the data you need to apply a much more complete customer lifetime value formula:

Would you like to calculate the Lifetime Value for your company? You can download our free LTV calculator template here: