Customer Lifetime Value

Customer lifetime value or LTV is the company's total revenue from one customer during its lifetime. It helps predict customers' responses and spending on their products and services. 

The importance of customer lifetime value lies in forecasting the company's future sales. It enables individual businesses and organizations about future insights on product development, marketing, and customer support. In addition, it helps to maintain steady cash flow by bringing loyal customers. However, ignoring the LTV can impact the firm's profitability figures.

• Customer lifetime value is the average company sales derived from a single client. It helps the company identify potential loyal customers that will generate future sales.
• The two types of LTV models include historical and predictive approaches. These approaches use cohort, aggregate, probabilistic, and machine learning techniques.
• The formula to calculate it is Customer Lifetime Value (LTV) = Average Value of Sale × Number of Transactions × Retention time × Profit Margin
• Companies can improve the LTV by improving communication, customer experience, and welcoming return back policies

Customer Lifetime Value (LTV) refers to the projected revenue that a business earns from one customer. It estimates the money a company will gain throughout a customer's lifetime. In addition, it determines how much they should invest in retaining a single customer. 

Since LTV is a long-term concept, it is necessary to understand that not all customers are equally important. Therefore, the company focuses on certain targeted customers more than others. The customer lifetime value prediction helps in getting the most profitable customers. In addition, it helps identify the potential audience that will increase its future cash flows. 

Customer lifetime value depends on the pre-existing data and future behavior of customers. Following are the types of lifetime value customers:

#1 - Historical LTV

As the name suggests, historical LTV refers to using past data to find customer value. It uses aggregate and cohort models to find the LTV. This model is useful when a certain customer group is loyal to a business. However, it neglects existing and inactive customers. Also, the historical LTV might be inappropriate since some inactive members might buy products in the future. 

#2 - Predictive LTV

The predictive LTV forecasts customer behavior using machine learning and a probabilistic model. The companies use different coding systems to identify the potential audience. Also, it points out factors that can improve customer retention and sales. 

Certain factors weigh down the LTV, disrupting the brand image in the customer's mind. For example, if an active customer feels unvalued, there might be negative rumors or information about the brand. It is likely to impact the customer lifetime value prediction. Thus, it is necessary to understand the impact of these factors on the company. Let us look at them:

#1 - Churn Rate

Active customers stop buying and turn into inactive customers at a churn rate. Startups and small businesses have a high churn rate. It helps in understanding the effect of lifetime value prediction. This rate differs from business to business based on competitive advantage. 

To calculate the churn rate, subtract the customers at the end of the period from those at the beginning. Then, divide the difference by the initial customers. For example, a startup had 800 customers initially, and now the number dropped to 600. Therefore, the churn rate is 25% indicating that 25% of customers have switched to another brand. 

#2 - Brand Loyalty

The number of customers loyal to a brand determines the customer retention percentage. These loyal customers act as marketing agents that spread awareness about the business. Therefore, highly loyal customers will decrease the churn rate and improve LTV. For example, a 2021 report by Consumer Intelligence Research Partner (CIRP) states that 90% of customers choose Apple products compared to other brands. In contrast, the customer retention period of Samsung is 38%. 

Here is the customer lifetime value formula for calculating future customer estimates. 

Customer Lifetime Value (LTV) = Average Value of Sale × Number of Transactions × Retention time × Profit Margin

Here, 

• Average value of sale = average sales of the company.
• Number of transactions = average number of times a customer shops with them.
• Retention time = the number of days, months, or years a customer stays loyal to them.
• Profit margin = Average margin a company makes a profit.

However, there are two more formulas based on their types:

• Historical approach 

Customer lifetime value (LTV) = Total revenue for chosen period/ Total number of   customers

• Predictive approach 

Customer lifetime value (LTV) =          T x AOV x AGM x ALT/  Number of customers                                           for the period

Here, 

• T = The average Number of transactions per month
• AOV = Average order value (total revenue/ number of orders)
• AGM = Average gross margin (Total revenue (TR) - cost of sales/ TR x 100)

Let us look at an example of calculating a company's average customer lifetime value.

Suppose Jordan has been running a restaurant for the past three years. Every month, 100 customers visit his food joint. Out of these 100, three customers revisited the outlet four times in the past two years. The average sales of the outlet were $850, and the profit margin was 15%. Jordan wants to know the average sales one customer will generate in the future. Thus, he calculates the average customer lifetime value of his business.  

Customer Lifetime value = Average Value of Sale × Number of Transactions × Retention time × Profit Margin

                                              = $850 x 4 x 2 x 15%

                                              = $1020

This figure indicates that Jordan will have an estimated future cash flow of $1020 from its customers.

This article is a guide to Customer Lifetime Value (LTV) and its definition. We explain LTV types, formulae and ways to increase LTV. You can also go through our recommended articles on corporate finance –

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