If your company only tracks one metric, the one that should top the list is LTV (Lifetime Value). You are probably already tracking many KPIs, but the one that sits at the heart of your business is LTV.
LTV helps you monitor the analytics of your business in perpetuity while streamlining the customer acquisition strategy, marketing budget, and profitability.
In this article, we’ll discuss the typical ways of measuring LTV, and why that might be giving you wrong results. We will cover a few other factors that should be integrated into calculating LTV and show you the best way to calculate the right LTV.
What Is Customer Lifetime Value?
Customer lifetime value is simply the predicted amount a customer will spend on your product throughout their relationship with your business.
Measuring LTV is important for SaaS companies that want to understand how much acquiring and retaining customers costs. Plus, it helps you make more informed decisions when it comes to budgeting and forecasting.
LTV Formula: How People Typically Measure LTV
The most straightforward formula for measuring LTV in a subscription business is as follows:
LTV = customer lifetime ✕ gross profit
where gross profit is calculated as Average Revenue Per Account (ARPA) ✕ gross margin and customer lifetime as 1/customer churn rate.
Thus, the total calculation looks like this:
LTV = ARPA ✕ gross margin/customer churn rate
For example, if we calculate LTV using the above formula with a customer churn rate of 3% per month, an ARPA of $200 per month, and a gross margin of 80%, we get a customer lifetime of 33.33 months and an LTV of $5,333.33.
You can also replace the customer churn rate with revenue churn rate. This provides a second type of churn rate. We will discuss this a bit more below.
For now, the formula to calculate LTV with the revenue churn rate is:
LTV = gross profit/revenue churn rate.
These formulas are a good start, but here are a few basics you should keep in mind when you calculate LTV using the above methods.
By default, many people calculate customer lifetime value not with gross profit but with revenue. The problem is that, if you calculate customer lifetime value using revenue in the formula, the projection will be overly optimistic. Therefore, it’s essential to use gross profit.
But what is gross profit? It’s the money left over after deducting all costs associated with providing your service from the revenue generated.
The formula is:
Company’s revenue − costs of goods sold = gross profit.
Coming to the next point, when calculating your churn rate, make sure you segregate the customers with annual plans from those with monthly plans.
The yearly customers are more significant when it comes time for renewal at the end of the year, so if you calculate monthly and annual subscribers together, the calculation will be a little messy. This is because you would be counting the customers that can cancel and those that can’t together.
Thus, when you have a mix of annual and monthly subscribers, you should measure their LTV separately to get more actionable information.
Some companies determine the LTV of customers that pay different amounts per month at the same time, but this might not give you the best information. Consider segmenting your customers based on how much they pay and measuring their LTV separately, so that you can make varying strategic decisions for your different service plans.
Measuring LTV for SaaS Companies: Why You Should Use Customer Churn Rate & Revenue Churn Rate
As mentioned above, calculating LTV with both customer churn rate and revenue churn rate is critically important for a business, especially subscription-based SaaS companies.
The customer churn rate tells you about the percentage of customers you lost, while the revenue churn rate, also known as MRR churn, informs you about how much your revenue is decreasing monthly.
For example, if your company loses ten customers that pay $1 per month, then your customer churn is 10 and your revenue churn is $10. Now, if your company lost one customer that paid $100 per month, then your customer churn decreases to 1, but the revenue lost with that one churn is $100.
So, if you do not calculate LTV with customer churn rate and revenue churn rate, then you cannot get an accurate representation of your company’s financial health. The various formulas for measuring LTV give you different information, and they should all be used.
You need to know the value of your customers, i.e., the revenue or loss they are generating, which requires calculating LTV with both customer churn rate and revenue churn rate.
When you need customer churn and revenue churn data, there’s no need to battle through datasheets to do the calculation. Use Baremetrics to give you accurate insight into both. It’ll make the rest of your calculations effortless and accurate.
Interesting Read: Do Churn-Based LTV Calculations Mislead Us?
Use Gross Profit, Not Revenue
When you have a small SaaS business, you do not have many employees and the profit margin is high, often 85–95%. So, measuring LTV with revenue is acceptable.
But, as your enterprise matures and with it has larger expenses and more employees, you can no longer rely on revenue-backed LTV. To scale your business safely, you need to use gross profit instead of revenue.
Imagine you spend $10, including all company costs, to acquire a single customer. Then, that customer subscribed to your service for three months at $10 per month. The calculation would look like this:
LTV = 3 purchases ✕ $10 = $30.
This results in your LTV being greater than your CAC (Customer Acquisition Costs).
When your CAC is lower than your LTV, and your LTV is rather high, the service can be a money-making machine for your business.
However, don’t calculate LTV with revenue as it overestimates the value of your customers and can have you spending far more to acquire new customers than is prudent; instead, use gross.
Negative Churn and Your LTV: What It Means & Why It’s a Problem
Every CEO of a SaaS business craves negative churn. This means that your expansion revenue from existing customers is greater than the lost revenue from their churn. This expansion revenue does not include income from any new customers, just the existing ones.
Sounds great, right? Well, achieving this is not as straightforward as it seems to be, although it is doable and SaaS companies actively work on achieving this goal, declaring it to be their primary focal point.
LTV becomes infinite when calculating it based on the above formulas if your company has negative churn or a very long customer lifetime
Here is where the problem lies: If you have a very long customer lifetime or have achieved the milestone of negative churn when you calculate LTV, it will result infinite, which is impossible. So, the formulas break down here since they show results that are not rational.
David Skok, a serial entrepreneur who has a great passion for helping entrepreneurs and startups, suggests different formulas for use with negative churn. With his experience and elaborative guide, he explains how to calculate LTV with negative churn in his article “What’s your TRUE customer lifetime value.”
In the article, he suggests assuming a positive churn rate, which makes sense as the churn rate cannot be lower than zero.
Here is an example of how to use his suggested formulas. If the negative churn rate of your company is 12%, then you should take it as the result of two variables:
- The customer churn rate: Let’s say this is 10% annually.
- Growth in the spend from your remaining customers: Let’s say this is 22% of the contract amount you initially had at the beginning of the period.
Thus, in this case, instead of calculating your LTV with a negative churn rate, use 10% for churn, while the 22% growth in existing customer sales can be factored in elsewhere when projecting your future revenue growth.
In addition, he suggests that you should assume existing customers will increase their spending by a certain percentage from the original contract value over time. In this way, the lost revenue from churned customers will eventually be balanced by the expansion of the average sale from retained customers.
The Better Way to Measure LTV
The following steps will improve your LTV measurement process:
- Collect the revenue retention data of your existing customers.
- Analyze the future revenue development of each cohort of customers separately.
- Calculate your LTV based on the NPV (Net Present Value) of your projected revenue streams.
Here is a real-time example in a Google Sheet you can follow to calculate your LTV.
This sheet has examples of the LTV calculation and cohort-based projection of LTV. To calculate your own LTV, you can copy or download the sheet and replace the sample data with your own. Or, you can simply use the formula below to get your results.
Instead of the original formula of LTV = ARPA ✕ (gross margin/customer churn rate), David Skok suggests an advanced procedure to calculate the LTV realistically:
LTV = ARPA ✕ gross margin ✕ (1/(1 − K) + (G ✕ K)/((1 − K)2))
The concepts of G and K can be explained as follows:
- G is the annual growth rate of the customers that you have retained. It can be seen as the business expansion rate of existing customers. Using this in the formula will turn the negative MRR churn value into a positive number.
- K is a value deflator. K is based on both the customer churn rate and the discount rate. The discount rate decreases the value of money over time according to interest rates.
The formula for K is given below.
K = (1 − customer churn rate) ✕ (1 − discount rate)
The LTV calculated using the above data and formula will be accurate and not overly optimistic. When measuring LTV, these are the essentials for an accurate calculation.
Note the points mentioned above and make sure to have only the most accurate data for the best LTV approximation, and remember that LTV is always an approximation as you can only know the actual lifetime value of a customer after they have churned.
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