Customer Lifetime Value (LTV)

Customer Lifetime Value (LTV) is a metric that estimates the value of one customer over their full life of being a customer.

LTV is also commonly referred to as CLV or CLTV. They all reference customer lifetime value. 

LTV can be difficult to conceptualize and hard to compute (particularly if you have limited historical data). But that’s what this article is here to help you with today. 

I will breakdown the components of the LTV formula and answer the following questions for you: 

• What is the customer lifetime value (LTV)?
• Why does LTV matter?
• How do you calculate LTV?
• How do you increase LTV?

Why does LTV matter?

Customer Lifetime Value is important to understand so that you can make strategic decisions and allocate resources effectively. 

LTV is particularly important when considering how much you can spend to acquire a new customer, see LTV:CAC Ratio. 

In subscription software businesses (SaaS), customers often pay smaller monthly amounts, but over a longer period of time. So while the customer has not paid you very much upfront, the amount they pay you overtime as a customer becomes meaningful. 

For example, if your average monthly churn is 1%, your average customer sticks around for 100 months or 8.3 years (1 / .01). Now imagine that customer pays you $25/mo. 100 months x $25/mo = $2,500 in revenue. That’s much more interesting.

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How do you calculate LTV?

Before you start crunching numbers, think about how you want to use the LTV formula. Are you looking to analyze your entire customer base? Do you want to look at specific cohorts? Are you interested in customers by industry? 

Start with the question you’re looking to answer and how you want to use the calculation before jumping into the numbers. 

Now that you’re ready, calculate customer lifetime value using these 4 elements:

• Period: This part always confused me. In subscription businesses, you could look at monthly recurring revenue or annual recurring revenue or some other recurring period. No matter your choice, make sure you keep your period consistent with the churn metric that you use, as you’ll see below.  
• Average Revenue Per User (ARPU): This is often referred to as average revenue per account or average monthly recurring revenue. It all depends on your business. It’s simply the average revenue over the period you are measuring. The average revenue per user, or ARPU in a SaaS business is often how much revenue an average customer pays you each month — for example, $25/month.
• Gross Margin: This is a percentage of gross profit you make on average for each customer. It’s the ARPU minus the cost of goods sold (COGS). This is important because we want to evaluate the profit value of a customer net of servicing them. 
• Churn Rate: For subscription businesses: the churn rate is defined as “the percentage of customers who cancel their subscriptions during a certain period, usually monthly or annually." So if 100 people sign up for your service and 5 of them cancel after 1 month, while 95 renew their subscription, that's a 5% monthly churn rate. Churn rates vary widely between industries and companies; however they usually fall within 1%-5% range unless there are major underlying issues causing customers to not renew their contracts.

The customer lifetime value (LTV) formula is used in the LTV calculation example below. 

Average Revenue Per User (ARPU) x % Gross Margin / Churn Rate = LTV

Let’s break those components down. Let’s say your ARPU is $25/mo. That’s $25 of monthly recurring revenue (MRR). Then let’s say it costs you 5-20% to service that customer (cost of goods sold, think hosting costs, credit card fees, support cost). Let’s assume 10%. So your Gross Margin equals 100% - 10% COGS = 90% gross margin. Then lastly, let’s assume your monthly churn rate is 5%. Here’s your LTV calculation: 

$25 MRR x 90% / 5% = $450 LTV

That’s a customer lifetime value of $450. Now, a general rule of thumb is that you want to achieve at least a 3X LTV:CAC ratio. So this would mean, you should not spend more than $450 / 3 = $150 to acquire that customer.  

How do you increase LTV?

There are 3 ways to increase your customer lifetime value. Look at the numerators in the equation. 

1. ARPU: Can you charge more for your product? Can you sell more products to customers? 
2. Gross Margin: Can you reduce the cost to service your customers? 
3. Churn Rate: Can you build a better product and provide a better service, so fewer customers leave you?

That’s really it. 

Take a close look at the Ideal Customer Profile (ICP) Template. At our venture-backed, B2B SaaS company, before we calculated LTV, we did a deep dive into who our ideal customers really are. This helped us be able to run an LTV analysis looking at the highest value customers across different customer attributes.