It's an important economic metric tool that has nothing to do with actual financial reporting, but instead moves into the world of what-might-be, based on what actually is. If you are thinking of growing your business, calculating your projected LTV will help you decide whether it's scalable or not.
- An LTV model doesn't necessarily require hard data
- LTV compares preferentially to CAC (Customer Acquisition Cost)
- Historical data can be incorporated
- Some mathematical formulae may then be necessary
A scalable business is one that has the potential to increase its profits without greatly increasing its costs. If you have a successful product and business model, and you're thinking you might be ready to expand into new markets, then you'll probably want to assess your scalability. As a general rule, intangible products like software tend to scale easily, since most of the costs involved are with the initial set-up, while anything that provides personnel or services is likely to increase its costs as time goes on.
LTV vs CAC
LTV is increasingly used as a business metric, together with another form of calculation known as Customer Acquisition Cost (CAC), which refers to any outlay involved in actually acquiring customers, such as marketing, advertising, etc. An increased use of economic theorizing with computers sees these two metrics sitting opposite each other on a computational balance, each trying to outweigh the other in determining the potential of your business.
Simple CAC is calculated by dividing the number of customers you acquired (A) by the costs of acquiring them (B):
- If A = 100 and B = 10, then CAC = 0.1
- If A = 100 and B = 100, then CAC = 1
- If A = 100 and B = 1,000, then CAC = 10, etc
Simple LTV is calculated by estimating the years of the customer's business life (D) and multiplying it by the annual income you received or expect to receive (E)*:
- If D = 1 and E = 100, then LTV = 100
- If D = 10 and E = 100, then LTV = 1,000
- If D = 10 and E = 1,000, then LTV = 10,000, etc
*At a very basic level, though there are many other variables to consider.
So then, if your CAC is 100 and your LTV is 100, your business is going to stagnate, but if your CAC is 10 and your LTV is 1,000, your prospects for scalability are much better. If your CAC is 1,000, though, and your LTV is only 100, you're in trouble.
Put simplistically, there are three possible outcomes:
LTV > CAC = Business Growth
If your LTV is greater than your CAC for the period of the projected business relationship, you will not only recoup your CAC but crucially also generate additional revenue during that period. With this outcome your business will grow and be able to acquire more customers with fewer costs. In this scenario, the business will scale up and become more profitable with each customer acquisition.
LTV < CAC = Business Failure
If it costs you more to acquire your customers than you are likely to get back over the business lifetime, then your business will not prosper. In this scenario, the amount of money you lose increases as you acquire more customers, and the faster you expand, the faster you'll go broke.
LTV = CAC = Business Stagnation
If you expend the same amount of money to acquire a customer as you'll get back over the business' lifetime, your business will go nowhere. From a cash flow point of view, you’ll be in the red for the whole business lifetime, because it will take that whole lifetime to recoup the initial amount you spent on acquiring them.
So, in order for your business not to fail or stagnate, you need your LTV to exceed your CAC, and preferably to direct your business growth towards the solid core of customers whose LTV is likely to be the greatest.
The 'Pareto Principle'
The 'Pareto Principle' is a business management postulate, also called
- the '80/20 rule'
- the 'principle of factor sparsity' or
- the 'law of the vital few'
It states that, in the majority of cases, around 80% of effects derive from 20% of causes. When applied to business, this means that 80% of your income will derive from 20% of your customers. You can also use the historical data of your customers' existing lifetime with the business as a basis to form your projections using the Pareto Principle.
How do I Model LTV?
If you don't have any data, then you'll be modeling your LTV on quantum projections based solely on your expectations. You need to keep those expectations realistic, as you may need to justify them later to potential investors. In any event, it's just a projection and not an accurate figure, and the further ahead you project, the more speculative will be your results.
If you do have data to go on, and you are able to cope with mathematical equations, then there are calculations you can do which will project an LTV model into the future. There are several variables that apply to these calculations, such as how long you’ve been in business and how much historical data you have, taking into account also financial variables such as depreciation, interest rates and the future value of money. There are several different approaches, and a software program such as ChartMogul will be able to do it all for you.
If you apply the LTV calculation to the vital few 20%, these are the ones who will provide the most accurate results, since these are the ones who are going to stick with you and provide you with the steadiest profits. Taking LTV into account when assessing scalability may also make you revise your customer acquisition policy. Instead of aiming to increase your customer base cheaply on a large scale, you can optimize your scaling budget towards delivering greater value to a smaller core of potential lifetime customers.