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ustomer Lifetime Value (LTV) indicates the projected financial worth that an individual customer brings to your business throughout their relationship with you. It’s a key element in making data-driven decisions.
By calculating each customer’s LTV, you can determine their total financial contribution to your business. You can use this metric to formulate effective customer retention strategies that strengthen their engagement with your business, boost your profitability, and increase your potential for sustained growth.
Defining customer lifetime value
In simple terms, LTV represents the total revenue you can expect from a customer during their entire relationship with your business. It’s the financial story of your customer's journey with you, from their first purchase to their last.
So, what variables do you need to calculate LTV? You must examine three main things:
- Average order value (AOV): The average amount that your customers spend on each purchase
- Purchase frequency: How often the average customer buys from you
- Customer lifespan: How long your customers tend to continue buying from you after their first purchase
As you know, not all customers are equally valuable, which is why you can combine customer segmentation strategies with LTV. By dividing your customer base into segments based on characteristics like purchasing behavior, demographic traits, or product preferences, you can calculate the LTV for different groups of customers.
With this information, you can understand the nuances of each customer group. One segment may have a higher purchase frequency, while another tends to have a longer lifespan. Understanding these differences allows you to tailor your marketing strategies to nurture and grow each segment effectively, ultimately enhancing their respective LTVs.
Before you can calculate the long-term value of your customers, you’ll need to collect the right data, which helps you understand customer buying patterns and frequency.
Begin by examining your customers' purchase history:
- Collect information from sales records, your CRM system, or your e-commerce platform.
- Look at the total amount spent per transaction as well as the patterns of their purchases.
For calculating LTV, collect the following mandatory metrics:
- Total revenue
- Total number of orders
- Total number of customers
- Length of time between first and last orders for each customer
You can also consider the following optional metrics:
- Repeat purchase rate: This is calculated by dividing the number of customers who have made more than one purchase by the total number of customers. It provides insight into customer loyalty and their inclination to purchase repeatedly from your business.
- Customer churn rate: This represents the percentage of customers who stop buying from you over a specific period. Calculate it by dividing the number of customers lost during a period by the total number of customers at the start of that period. It's a significant indicator of your ability to retain customers.
Once you have your data, you're ready to calculate LTV. Here's how:
- Compute the average purchase value (APV): Divide total revenue by total purchases for a period. For example, if monthly revenue is $10,000 from 200 sales, APV is $50.
- Find the average purchase frequency rate (APFR): Divide total purchases by total unique customers for a period. If 200 purchases are from 50 customers monthly, your APFR is 4.
- Derive the customer value (CV): Multiply APV by APFR. In this case, CV equals $200.
- Estimate the average customer lifespan (ACL): Determine how long a customer stays with your business by averaging the number of years that a customer continues buying your products or services.
- Calculate the LTV: Multiply CV by ACL. If ACL is three years, your LTV is $600.
Having your overall LTV is good to understand the bigger picture of your customer relationships. You should also calculate LTV for each of your customer segments so you can compare groups and identify important patterns you can learn from.
Interpreting and utilizing LTV
Your customer lifetime value can tell you much about your business’s health and long-term prospects. A higher LTV indicates a higher value per customer, suggesting that your customers are loyal, purchase frequently, or make substantial purchases. On the other hand, a lower LTV may indicate the need for improvement in areas such as customer retention or purchase value.
Long-term value and customer acquisition cost (CAC)
When interpreting your LTV, consider it alongside your customer acquisition cost (CAC). CAC is the total cost of acquiring a new customer, including marketing, sales, and other related expenses. When you compare LTV to CAC, you’ll get an essential perspective on your investment return.
If your LTV is higher than your CAC, you're getting a good return on your investment in marketing and acquiring new customers. But if your CAC is higher, you spend more to reach customers than they bring in. In this case, you need to reevaluate your acquisition strategies or find ways to increase your LTV.
Using long-term value in customer retention
You can also use LTV as a customer retention strategy benchmark. Knowing your LTV can help you decide how much time and money is worth spending on your customer retention efforts.
Next, consider your churn rate and repeat purchase rate to see if you're facing issues with keeping your customers interested. If your churn rate is high or your repeat purchase rate is low, you may want to consider strategies to better engage with and provide value to your customers.
Strategies to boost LTV
Several tactics can help increase your LTV:
- Upselling encourages customers to purchase a higher-end product or add-on, thereby increasing the average purchase value.
- Cross-selling attempts to persuade customers to buy related or complementary products, thus increasing purchase frequency.
- Customer loyalty programs boost purchase frequency and lifespan by incentivizing repeat purchases and fostering long-term customer relationships.
Understanding and applying LTV in your business decisions can significantly increase customer retention, profitability, and long-term success.
Advanced techniques and considerations
Once you understand the basics of LTV, you can delve deeper for a more nuanced understanding of your customers' behaviors and value. Customer referrals, brand advocacy, and non-purchase interactions can contribute to a customer's value. Including these elements in your LTV calculations can offer a more holistic view of your customers' worth.
For example, discounted cash flow (DCF) analysis considers the future value of something, which in this case is a customer's cash flows, and discounts them to present value terms. DCF is informative because a dollar earned today is worth more than one earned in the future due to inflation and investment opportunities.
Another technique to enhance your understanding of LTV is cohort analysis. Instead of looking at all customers as a single group, cohort analysis allows you to group customers based on shared characteristics like acquisition date, first purchase product, or demographics. Tracking the behavior of these cohorts over time can provide valuable insights into patterns, trends, and variations in LTV.
While these advanced techniques can provide more accurate and nuanced insights, calculating LTV also comes with limitations and challenges. LTV calculations are based on averages and historical data, which might not always accurately predict future behavior. New businesses or those with rapidly changing customer bases might find it particularly difficult to estimate LTV accurately.
LTV is not just a metric—it's a narrative about your customers, their loyalty, and the financial value they bring to your business over time. Whether you're a seasoned business owner or a startup entrepreneur, understanding LTV can be a game changer. It helps you assess the health of your customer base, evaluate the returns on your marketing investments, and make informed decisions about customer acquisition and retention strategies.
LTV might seem daunting at first, but now you know it's a valuable tool that's well within your reach. Take the plunge, calculate your LTV, analyze its insights, and let it steer your business toward sustained growth and success. Novo's business banking solutions can help you keep track of the financial data you need to calculate LTV.
Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.
Novo is a fintech, not a bank. Banking services provided by Middlesex Federal Savings, F.A.: Member FDIC.
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