Understand the Customer Lifetime Value (CLV) Concept

## How to Calculate CLV

The customer lifetime value (CLV) is defined as the monetary value contributed by a customer to a company across the entire time of doing business together.

CLV is an essential metric that can help a company set a “ceiling” (i.e. the maximum amount) on how much it can afford to spend on acquiring new customers based on how profitable the average customer has been in the past.

Most often, the customer lifetime value (CLV) metric is tracked for companies with a subscription-based business model with repeat purchases, and less often tracked for those companies with “one-time” purchase models.

By tracking CLV, a company can quantify how much it could afford to spend to acquire new customers going forward – which leads to more efficient capital allocation in terms of activities like marketing.

Additionally, with CLV, the company can better estimate its future cash flows and the number of new customers that its sales team must obtain for the company to become profitable.

## CLV/CAC Ratio

For a company to be sustainable, the cost of acquiring one new customer – the customer acquisition cost (CAC) – should be lower than the lifetime value (LTV) of that same new customer.

Hence, one of the most widely used metrics in SaaS investing is the LTV/CAC ratio, which compares the inflow of customer profit and outflow of spending required to acquire that customer.

LTV is most meaningful when compared to customer acquisition costs (CAC), and by itself, the metric does not provide much insight.

In the SaaS industry, the target LTV/CAC ratio is 3.0x, which means that for each dollar spent to acquire customers, the company should be receiving \$3.00 of value in return.

## CLV Formula

One of the simplest methods to calculate the LTV is to divide the average amount of gross profit each month from a typical customer by the monthly churn rate assumption.

###### CLV Formula
• Customer Lifetime Value = (ARPA * Gross Margin) / Churn Rate

The churn rate is defined as the pace at which a company expects to lose revenue caused by the loss of customers across a specified period, which is monthly in our case.

However, note that calculating LTV differs by the individual and/or firm, so various measures of operating performance could be used with further adjustments made as needed.

In our LTV formula, the underlying drivers with the most impact are:

• Average Revenue Per Account (ARPA): ARPA is calculated by dividing total revenue over a period by the total number of active customer accounts under the same time frame.
• Gross Margin %: Gross margin is the amount of profit remaining after subtracting the direct costs of the service – e.g. application hosting costs, new customer onboarding, customer service, third-party software licenses.
• Churn Rate: Churn refers to the discontinued revenue attributable to existing customers that are no longer expected to remain customers – and the concept is directly associated with the average customer lifetime, which is the length of time a customer makes purchases from the company before stopping.
###### Discount Rate in LTV Formula

LTV calculations assume customers produce a certain amount of revenue (and therefore profit) each month or year for a seller (i.e. the company).

Considering the “time value of money”, any future cash flows expected to be received hold less value in comparison to if payment was received on the present date – thus, a discount rate is often attached to calculating LTV.

However, for illustrative purposes and for simplicity, we’ll be using a more basic calculation of LTV.

## How to Increase CLV

Since the lifetime value measures the profit that customers contribute across the duration of the business relationship, it would clearly be in the best interests of companies to increase the LTV.

CLV is one of the most important considerations when projecting revenue and costs/expenses because if economic benefits (i.e. profits) from each customer do not justify the spending, the company eventually will deplete its entire cash reserves and shut down.

Based on the estimated CLV of the existing customer base, several departments within a company will adjust their budgets and projected spending accordingly, such as:

• Product Development Costs
• Sales and Marketing Expenses (S&M)

CLV can also impact the current pricing structure of a company’s line-up of products and/or services – or in more concerning cases, could lead to a complete overhaul as a final “Hail Mary” attempt to keep the company afloat.

If a company’s target (or “optimal”) CLV has been reached, that means the current strategies in place and budgets are promising, even if further adjustments in the future are inevitable.

But for the time being, the current spending on acquiring new customers and retaining existing customers via continued engagement (i.e. to minimize churn) is putting the company on track to ultimately become profitable (or improve its margins).

###### CLV in Cohort Analytics

Most companies, once a milestone regarding the valuation size or customer count has been reached, begin segmenting CLV by customer types (i.e. cohort analytics) in more detail to identify the profitable (and less profitable) areas and customer bases to which to shift their focus.

Cohort analytics consists of breaking down the existing user base into groups of customers with shared traits (e.g. date of acquisition, income level, number of employees).

Post-segmentation, a company can better understand their users’ behavioral patterns and spot trends, which are insights that the management team can use to its benefit (e.g. upsell to certain customer groups, defensive measures to reduce the likelihood of churn).

## CLV Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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## CLV Calculation Example

For our modeling exercise, the following assumptions will be used:

Based on the stated assumptions, our company is generating \$1m in recurring revenue each month with 50 paid subscribers (i.e. customer user accounts).

By dividing the MRR by the paying subscriber count, we arrive at the average revenue per account (ARPA).

• Average Revenue Per Account (ARPA) = \$1m MRR ÷ 50 Accounts
• ARPA = \$20k

Therefore, the company derives \$20k in monthly revenue from each customer account on average.

In the next step, we multiply the ARPA value by the gross margin % assumption, which will be hard-coded as 80.0% here.

• Gross Contribution Per Customer = \$20k ARPA × 80.0% Gross Margin
• Gross Contribution Per Customer = \$16k

Each month, the average customer contributes \$16k in profits to the company – which we calculated using a simple gross margin % with no other adjustments.

In the final step, we divide the gross contribution per customer by the monthly churn rate, which is assumed to be 2.5% here.

• CLV = \$16k Gross Contribution Per Customer ÷ 2.5% Monthly Churn
• CLV = \$640k

The takeaway is that for this hypothetical company, one customer is expected to generate a total of \$640k in profits throughout his/her entire lifespan as a customer.

Whether the \$640k LTV value is positive (or negative) depends on the customer acquisition costs (CAC), which is the amount spent to convince the customer to initially purchase the company’s products/services.

Let’s say that for our company, it has historically cost \$640K to acquire one new customer. In that scenario, the LTV/CAC ratio is equal to roughly 1.0x (i.e. break-even).

If our company wants to become more profitable, the LTV/CAC ratio of 1.0x is a potential red flag implying that urgent changes to the business model might be required.

But assuming the CAC was \$213k instead, the LTV/CAC ratio comes out to 3.0x, which is right where the company should want to be in order to be the best positioned for sustainable, long-term growth.

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