Customer lifetime value (LTV) is one of the most important metrics to measure at any growing company. By measuring LTV in relation to cost of customer acquisition (CAC), companies can measure how long it takes to recoup the investment required to earn a new customer -- such as the cost of sales and marketing.
If you want your business to acquire and retain highly valuable customers, then it's essential that your team learns what customer lifetime value is and how to calculate it.
Customer Lifetime Value
Customer lifetime value is the metric that indicates the total revenue a business can reasonably expect from a single customer account. It considers a customer's revenue value, and compares that number to the company's predicted customer lifespan. Businesses use this metric to identify significant customer segments that are the most valuable to the company.
LTV tells companies how much revenue they can expect one customer to generate over the course of the business relationship. The longer a customer continues to purchase from a company, the greater their lifetime value becomes.
This is something that customer support and success teams have direct influence over during the customer's journey. Customer support reps and customer success managers play key roles in solving problems and offering recommendations that influence customers to stay loyal to a company -- or to churn.
How to Calculate LTV
To calculate customer lifetime value you need to calculate average purchase value, and then multiply that number by the average purchase frequency rate to determine customer value. Then, once you calculate average customer lifespan, you can multiply that by customer value to determine customer lifetime value.
Getting stuck with the math? We did too. So let's break it down step-by-step together.
Customer Lifetime Value Model
Calculate average purchase value: Calculate this number by dividing your company's total revenue in a time period (usually one year) by the number of purchases over the course of that same time period.
Calculate average purchase frequency rate: Calculate this number by dividing the number of purchases over the course of the time period by the number of unique customers who made purchases during that time period.
Calculate customer value: Calculate this number by multiplying the average purchase value by the average purchase frequency rate.
Calculate average customer lifespan: Calculate this number by averaging out the number of years a customer continues purchasing from your company.
Then, calculate LTV by multiplying customer value by the average customer lifespan. This will give you an estimate of how much revenue you can reasonably expect an average customer to generate for your company over the course of their relationship with you.
Customer Lifetime Value Example
Using data from a Kissmetrics report, we can take Starbucks as an example for determining LTV. Their report measures the weekly purchasing habits of five customers, then averages their total values together. By following the steps listed above, we can use this information to calculate the average lifetime value of a Starbucks customer.
1. Calculate the average purchase value.
First, we need to measure their average purchase value. According to Kissmetrics, the average Starbucks customer spends about $5.90 each visit. We can calculate this by averaging the money spent by a customer in each visit during the week. For example, if I went to Starbucks three times, and spent nine dollars total, my average purchase value would be three dollars.
Once we calculate the average purchase value for one customer, we can repeat the process for the other five. After that, add each average together, then divide that value by the number of customers surveyed (five) to get the average purchase value.
2. Calculate the average purchase frequency rate.
The next step to calculating LTV is to measure the average purchase frequency rate. In the case of Starbucks, we need to know how many visits the average customer makes to one of their locations within a week. The average observed across the five customers in the report was found to be 4.2 visits. This makes our average purchase frequency rate 4.2.
3. Calculate the average customer's value.
Now that we know what the average customer spends and how many times they visit in a week, we can determine their customer value. To do this, we have to look at all five customers individually, and then multiply their average purchase value by their average purchase frequency rate. This lets us know how much revenue the customer is worth to Starbucks within the course of a week. Once we repeat this calculation for all five customers, we average their values together to get the average customer's value of $24.30.
4. Calculate the average customer's lifetime span.
While it's not specifically stated how Kissmetrics measured Starbucks' average customer lifetime span, it does list this value as 20 years. If we were to calculate Starbucks' average customer lifespan we would have to look at the number of years that each customer frequented Starbucks. Then we could average the values together to get 20 years. If you don't have 20 years to wait and verify that, one way to estimate customer lifespan is to divide 1 by your churn rate percentage.
5. Calculate your customer's lifetime value.
Once we have determined the average customer value as well as the average customer lifespan, we can use this data to calculate LTV. In this case, we first need to multiply the average customer value by 52. Since we were measuring customers on their weekly habits, we need to multiply their customer value by 52 to reflect an annual average. After that, multiply this number by the customer lifespan value (20) to get LTV. For Starbucks customers, that value turns out to be $25,272 (52 x 24.30 x 20= 25,272).
Improving Customer Lifetime Value
Now that you know your customer lifetime value, how do you improve it? While there are a number of ways to gain revenue, customer satisfaction and customer retention are two key ways to increase your customer's LTV.
Making your customers happier will usually result in them spending more money at your company. According to HubSpot Research, 55% of growing companies think it's "very important" to invest in customer service programs. If we look at companies with stagnant or decreasing revenue, only 29% said this investment was "very important." Companies that are actively geared towards their customer's success are experiencing more revenue because of increased customer satisfaction.
Acquiring a new customer can be a costly affair. In fact, an article published by Harvard Business Review, found that gaining a customer can cost anywhere between five and 25 times more than retaining an existing one. Additionally, a study conducted by Bain & Company found that a 5% increase in retention rate can lead to an increase in profit between 25% to 95%. This makes it imperative that your business identifies and nurtures the most valuable customers that interact with your company. By doing so, you'll gain more total revenue resulting in an increase in customer lifetime value.