# Lesson #79: Determining Customer Lifetime Value

Posted By: George Deeb - 8/22/2011

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Customer lifetime value (LTV) is the net present value of dollars attributed to one customer over their entire life as a customer.  LTV is a critical calculation in your marketing efforts, in determining an appropriate customer cost of acquisition (COA).  With the ever rising costs of customer acquisition, LTV is playing a more important role in determining the ROI efforts from your marketing spend.

The formula for calculating LTV is: (i) your average transaction size; (ii) times your average gross margin; (iii) times your average number of transactions per year; (iv) times the number of years a customer buys product from you; (v) times your retention rate of customers from one year to the next; (vi) less any marketing costs required to retain your customer over time; (vii) discounted back to present day dollars.   For number of years, I wouldn't model anything greater than five years.  For retention rate, I wouldn't model anything greater than 80% of the preceding year's customer base.  And, for your discount rate, that should be your weighted average cost of capital (somewhere around 10%--blending 5% cost on your debt and 15% required return on your equity, in one example).

As you can imagine, these inputs can wildly vary from one business to the next.  So, let's run through a couple examples.  In the first example, we have restaurant business, whose average transaction size is \$50 and customers come to the restaurant about 4x per year.  That suggests \$200 in revenues in year one, and then attritioning down (at 80% a year) to \$160 in year two, \$128 in year three, \$102 in year four and \$82 in year five.  So, total five year revenues per customer of \$672, on average, and total gross profit of \$224, assuming this restaurant averages a 33% gross margin.

If the average company spends 10% of their lifetime customer revenues to acquire the customer in the first place, that suggests this restaurant could spend up to \$67 in initial COA marketing.  As you can see, that would be a big loss looking at the first transaction in isolation (\$50 revenues less \$67 marketing).  But, you make up for the initial shortfall within the first year given the high frequency of purchase.  And, on a five year basis, this example will yield a profitable customer (\$224 in gross profit less \$67K in acquisition marketing less \$97 in retention marketing in years two through five).  To estimate retention marketing, assume retention marketing costs in year two are up to half of the original \$67 acquisition cost, or up to \$33 in year two.  Which then attritions down with the smaller customer base (the same 80% of the prior year level) to \$26 in year three, \$21 in year four and \$17 in year five, for a total of \$97 in years two through five.

So, net, at the end of five years, the customer drove \$672K in revenues (or \$224 in gross profit), less \$67K in original COA marketing, less \$97 for four years of retention marketing for a total profit of \$60, prior to discounting these cash flow back to their net present value.  The net present value of these cash flows using a 10% discount rate, is \$44, the LTV in this example.

In a second example, let's say we are a manufacturer of vacuum cleaners, whose average transaction size is \$250 and customers only buy one vacuum cleaner in the entire five year period.  That doesn't leave a lot of room for error in your marketing efforts, as you need to drive your entire LTV and a solid ROI on your marketing COA all at once.  With a 30% gross margin, or \$75 gross profit, this company needs to keep its marketing COA under \$50, to have a chance to drive a \$25, or 10%, profit.  And, even then, that doesn't take into account any back office and overhead costs, so it is probably better to cap COA at \$40 to cover those items.  So, your LTV in this example is \$250 in revenue (or \$75 in gross profit), less \$40 in acquistion cost, for a profit of \$35, your LTV.

Theoretically we could have modeled this customer over forty years, buying a new vacuum cleaner every ten years.  But, given the infrequent purchase behavior over a very long period of time, I would be conservative and make sure you drive a healthy profit from the first transaction, as who knows if you or your customer are going to be around ten years from now, waiting for that second transaction to close.