Getting users is obviously a crucial, if not the foremost aspect of developing a successful product. At the end of the day though (even if it’s several years in the future), you need to know how you’re going to turn a profit. To do so, you want to know whether or not the users you’re getting are actually users you’ll make money off of for a sustained period of time.

So how do you go about finding that out?

Understanding Customer Lifetime Value (LTV) is how you can ensure that your revenue is sustainable, and not just a flash in the pan. LTV is more than just a number; it's a critical insight into customer behavior and long-term profitability. In this guide, we’ll explore the definition of LTV, its significance in various industries, and provide a step-by-step guide to calculating it effectively. So let's get into what LTV means, why it's indispensable for modern businesses, and how you can leverage it to maximize your bottom line.

WHAT IS LIFETIME VALUE?

Lifetime Value or LTV, represents the total amount a customer is predicted to spend on your products or services during their lifetime with your brand. It's akin to trying to foresee the future by predicting how valuable a customer might be in the long run.

COMPONENTS

LTV is not a monolithic metric but a composite of various others:

Understanding these components is the first step toward an accurate calculation of LTV, enabling strategic decision-making in marketing and customer engagement.

Customer Expenditure

The average amount spent by the customer directly influences the overall LTV. Higher expenditure typically signals a more valuable customer, making it a crucial variable for analysts looking to optimize for long-term profitability.

‍Retention Rate

This metric directly impacts the 'Customer Lifespan' variable in the LTV formula. A higher Retention Rate extends the customer's lifespan, thereby boosting LTV. It's not just a churn predictor; it's a key lever for increasing lifetime value.

Profit Margins

Understanding the Profit Margins on each customer transaction allows you to refine the 'Average Purchase Value' variable in the LTV formula. Profit Margins can vary due to customer loyalty, seasonal promotions, or bulk purchases, which should be factored into the LTV to get a more accurate measure.

Discount Rate

In sophisticated LTV models, the Discount Rate is far from a static figure. It serves to discount future cash flows back to their present value, making it pivotal for an accurate LTV calculation. The ability to adjust the Discount Rate based on economic indicators allows for real-time refinements to LTV calculations, which in turn inform strategic decisions.

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CALCULATING LTV

Calculating LTV isn't just about crunching numbers. It's a strategic approach to understanding your customers' worth over time. Let's explore how to calculate LTV accurately and effectively.

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However, before doing so, you have to find the relevant metrics that would be used in calculating LTV in the first place.

PROCURING METRICS RELEVANT TO LTV

1: Average Purchase Value

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A. Collect Sales Data

‍Compile all sales transactions for a chosen time frame, such as a month.

• Example: Collect all sales for January.

B. Segment Customers

If applicable, categorize customers into groups, like new or returning.

• Example: Separate sales from new customers and returning customers.

C. Calculate Total Revenue

Add up the total sales revenue for that period.

• Example: If you made $10,000 in sales in January, that's your total revenue.

D. Divide by Number of Purchases

Divide the total revenue by the total number of purchases made.

• Example: If there were 500 purchases, the APV is $10,000 / 500 = $20.

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2: Purchase Frequency Rate

A. Define Time Period:

‍Decide on a consistent period for analysis, such as quarterly.

• Example: Analyze data from Q1.

B. Identify Repeat Customers

Find customers who made more than one purchase during that period.

• Example: Identify 150 customers who bought more than once in Q1.

C. Calculate Total Purchases

Count all purchases made by those repeat customers.

• Example: The 150 repeat customers made 300 purchases.

D. Divide by Number of Customers

Divide the total purchases by the number of repeat customers.

• Example: 300 purchases / 150 customers = 2, so the PFR is 2.

3: Average Customer Lifespan

A. Track Customer Engagement

Measure the duration between the first purchase and the last known purchase or interaction for individual customers.

• Example: Customer A stayed engaged for 3 years, Customer B for 5 years.

B. Analyze Churn Rate

Evaluate the percentage of customers who stopped purchasing over a specific period.

• Example: If 10% of customers stopped buying over a year, the churn rate is 10%.

C. Calculate Expected Lifespan Using Churn Rate

Utilize the churn rate to calculate the average expected lifespan of a customer. This can be done using the formula 1 / churn rate.

• Example: If the churn rate is 10%, the average expected lifespan is 1 / 0.10 = 10 years.

D. Calculate Overall Average Lifespan

Combine the individual engagement durations with the expected lifespan to find the overall average customer lifespan.

• Example: If you had individual engagement durations of 3 and 5 years, and an expected lifespan of 10 years, you might calculate an overall average lifespan considering both actual engagement and expected trends.

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CALCULATING LTV

GENERAL FORMULA

LTV=(Average Purchase Value×Purchase Frequency Rate)×Customer Lifespan

Let’s break down what this means:

STEP BY STEP GUIDE TO CALCULATING LTV

1: Calculate Average Purchase Value

• Determine the total revenue over a specific period and divide by the number of purchases.

• Example: If total revenue is $1000 and there were 50 purchases, the Average Purchase Value is $20.

2: Determine Purchase Frequency Rate

• Calculate how often customers buy within a specific time frame.

• Example: If 50 purchases were made by 25 customers over a month, the Purchase Frequency Rate is 2.

3: Calculate Customer Value

• Multiply the Average Purchase Value by the Purchase Frequency Rate.
  

• Example: $20 \times 2 = $40 Customer Value.

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4: Determine Average Customer Lifespan

• Estimate how long a customer will continue to purchase from your business.

• Example: If customers stay with your brand for an average of 5 years, that's the Customer Lifespan.

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5: Multiply the Customer Value by Customer Lifespan

LTV is one of many metrics that goes a long way in attaining your North Star of revenue growth and profitability. The data that goes into determining it and optimizing it can be quite unwieldy. This is why we’ve built Crunch-to save you time on parsing through data, and focus on the insights. Sign up for the waitlist here!

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