4 mistakes to avoid when calculating LTV
How much should I spend on my advertising campaign?
Which channel is bringing in the best customers?
Who are my best customers anyway?
These are just a few questions you might be asking yourself as someone looking to grow your business. Understanding your customers’ lifetime value can help you get there, but you should make sure to avoid some common mistakes. Before we get there, let’s review some important terms…
Lifetime value (LTV) is the present value of all future profits generated by a customer. Simply put, it’s a measure of what an individual is worth to your business. You may also hear LTV referred to as customer lifetime value (CLV).
Customer Acquisition Cost
Customer acquisition cost (CAC) is the amount you spend to gain one new customer. For most companies, “acquiring” a customer means getting them to their first purchase. However, for companies that make money through alternative means (eg. advertising), “acquiring” a customer simply means getting them to use their product. You may also hear CAC referred to as cost per acquisition (CPA).
Customer lifetime is simply the duration of time a customer remains an active user of your product or service. For example, if one day I sign up for Spotify and then close my account 10 months later, my lifetime as a customer was 10 months.
Now, on to those mistakes…
1. Using revenue instead of profits
Using revenue instead of profit to calculate your LTV can dramatically overvalue customers, leading you to believe you can spend far more to acquire them than is actually sustainable.
Consider a simple example…
Suppose you’re able to acquire a new customer for $10, and over the course of their customer lifetime, they purchase three items for $5 each. It’s tempting to look at this situation as follows:
LTV = 3 purchases x $5 = $15
CAC = $10
LTV > CAC
However, LTV should always be a measure of profit, not revenue. Let’s say your profit margin is 50%. This means that your LTV is really only $7.50 and you’re losing money on every new customer you acquire.
LTV < CAC
The misconception here is that all costs are built into CAC when they’re really not. CAC only takes into account the costs of actually acquiring new users, which has nothing to do with the other costs that might be affecting your margin on the products or services you’re selling.
Takeaway: LTV should be based on profit, not revenue.
2. Choosing an unrealistic customer lifetime
As a startup, you may not know your true customer lifetime. It may be continually changing as your product changes, so to calculate your LTV, you’ll have to guess. The initial number you decide on isn’t actually that important, since you can reevaluate it as more data comes in. The most important thing is that you pick a reasonable number.
Let’s say you have a subscription business with an estimated customer lifetime of 12 months. You know that your LTV will overtake CAC after only 10 months, which is fine if that’s true. However, you ultimately discover that you’ve overestimated your customer lifetime, and once again find yourself coming up short on LTV, as the customer drops off in month 6.
Instead of using an aspirational number, use a realistic one. If that means your estimated lifetime is only a few months at first, that’s fine. As you continue to work on your product, this will hopefully increase.
Takeaway: If you don’t have the data, make sure to choose a realistic customer lifetime for your LTV equation
3. Representing all customers with one LTV
Understanding LTV across all your customers is good, but the real magic comes from segmentation. By segmenting customers according to different characteristics, such as demographic information or purchase behavior, you can calculate separate LTVs and gain interesting insights about each of these segments.
Understanding LTV across all your customers is good, but the real magic comes from segmentation.
Let’s take the following situation…
LTV has been calculated as $50, so you feel confident in spending up to $50 to acquire new users.
However, you’ve just remembered the importance of segmenting your customers. Now you recalculate the numbers and find that organic customers actually have an LTV of $70, while customers acquired through your ads have an LTV of only $20.
It’s a good thing you didn’t start running ads for $40. If you hadn’t bothered to analyze the user base through segmentation, you might feel comfortable paying up to $50 to acquire new users. However, you now know that you don’t want to pay $40 for someone who’s only going to provide $20 in value.
This is just one example, but segmentation can be done using many different factors, such as demographic (maybe people in their 20s are spending twice as much as people in their 30s) or channel (maybe people who come from Facebook haven’t been nearly as valuable for you as those who come from search).
Takeaway: Calculate separate LTVs for different customer segments
4. Forgetting to recalculate LTV
In a startup, things are changing all the time. The products and services you offer will change, you might be trying out new growth channels, improving conversions, adjusting your messaging, and many other things.
With so much going on, it’s important to continually recalculate your LTV. Don’t be concerned if it moves around quite a bit. It probably will. No matter the company or product, LTV will always fluctuate as the market continues changing, but as long as you’re able to keep refining your model, you’ll be in a great position to make intelligent business decisions and growing your company in a sustainable way.
If you’re in a constant state of flux, you should probably recalculate LTV at least once per week. Otherwise, once per month may be fine.
Takeaway: Recalculate LTV frequently