Lifetime Value is the predicted amount a customer will spend on your product or service throughout the entire relationship, hence – “lifetime.” This metric can help you move from transaction-based thinking to focusing on the long-term value of repeat business.
To measure LTV, we’ll need additional metrics
1. Churn rate: This is the number of subscribers that unsubscribed or stopped paying in a given period of time.
Example: If you had 100 subscribers last year and lost 5, your churn rate is 5%.
Example: If you have 100 accounts, and from 50 of them you made $50 per year, and from the other 50 you made $100 per year, then your ARPU is $75 yearly.
3. Average Margin Per User (AMPU*):* This is the average amount of profit you receive from each account. You should subtract cost of goods sold (COGS) and account management and customer service expenses from your ARPU.
Example: Let’s say you’ve calculated that your ARPU minus expenses equals average margin per customer (AMPU) of 80%.
Calculating Lifetime Value
The simple formula for Lifetime Value looks like this:
(ARPU x Profit Per User)/Churn Rate
The first thing you to know is the average amount you’re profiting per customer. To calculate this with the example numbers above, find 80% of your ARPU which is $75. So, on a $75 subscriber, you’d net $60.
Next, find the lifetime value by factoring in the churn rate of 5%.
Lifetime Value = ($75 x 80%)/5%
Lifetime Value = $1,200
Other variables to consider: Churn variance and sample size
Quite often, churn can be messy. For example, if you think about any given cohort (a group of users that subscribed in a given period – i.e., all subscribers gained in July 2017), there’s often a “cliff,” right after the first month of that cohort’s start date.
To keep this churn variance accounted for, we can multiply our results by a discount rate. (Discount rate means “discounting” for cash flow losses that may occur in the future).
Use a discount rate of .75 to find a more conservative estimate:
((ARPU x Profit Per User)/Churn rate) x .75
$1200 x .75 = $900
Sample size is also important, and unfortunately, the scientific method often falls by the wayside in business. If you don’t have many users, or you’re counting too few users in your metric calculations, then your data may not be scientifically valid. Here are the scientific guidelines for sample size:
- Less than 100 users: 50% or more user data needs to be counted for valid data (100% is best)
- 1,000 to 10,000: 10% of user data needs to be counted for valid data, (i.e., if you’ve got 5,000 users then you need to include the data of at least 500 users in your calculations).
- More than 1 million: 1% of user data need to be counted for valid data, (i.e., if you’ve got 3,000,000 users then you need to include the data of at least 30,000 users in your calculations).
Put LTV to good use
Lifetime Value is an important metric, especially when matched with Customer Acquisition Costs (CAC). If you know how much a customer’s value will be over the course of a lifetime, then you can make smarter decisions about what to spend to acquire a customer. A good rule of thumb is that if LTV/CAC isn’t above 3, you’re spending too much on acquisition.