What it means:

LTV, or Lifetime Value, is a fundamental metric that measures the total revenue a customer is expected to generate throughout their entire relationship with your business. Imagine you operate a subscription-based streaming service like Spotify. When a user signs up, they are not just a one-time transaction; they represent ongoing revenue potential as long as they remain a subscriber. 

Why it matters:

Understanding LTV is crucial because it helps businesses gauge the long-term profitability of their customer relationships. It allows you to assess how much value each customer brings over time, which is essential for strategic decision-making.

By knowing the LTV of your customers, you can make informed choices about how much to invest in acquiring new customers (CAC) and retaining existing ones. For example, if the LTV of a customer is significantly higher than the CAC, it indicates that acquiring that customer is a profitable investment.

Furthermore, LTV is a key factor in segmenting customers. You can identify high-LTV customers and tailor marketing efforts and customer service to cater to their needs and preferences, thereby increasing customer satisfaction and loyalty.

Places it is used:

LTV is a vital metric used across industries, particularly in subscription-based services, e-commerce, and businesses with recurring revenue models. It plays a central role in determining marketing budgets, customer retention strategies, and pricing decisions.

For instance, in the SaaS industry, understanding LTV helps in setting subscription prices. If you know the average LTV of your customers, you can price your subscriptions to ensure that you not only recover your customer acquisition costs but also generate a healthy profit.

Where it gets tricky:

Calculating LTV can become complex when considering factors like customer churn rates, discounting, and the time value of money. Churn rates represent the percentage of customers who stop using your services, affecting the overall LTV calculation.

Discounts and promotions can also impact LTV, as they reduce the revenue generated per customer. It's essential to factor in these variables accurately to get a realistic LTV figure.

LTV may differ between customer segments or product lines within the same business. It's crucial to segment your customer base and calculate LTV separately for each group to make more targeted business decisions.

Formula:

For early stage companies, it can be hard to determine the lifetime value of a client when you only have a couple of years of historical data. There are a couple of ways to work around this. First, is to use the formula of (Average Annual Revenue per Customer * Gross Margin %) / (Annual Churn Rate). This formula will give you an approximate long term value for each customer.

However, this number can be astronomically high if you are at a phase where there is no significant churn. There are two ways that we often address this issue:

1. Use first year value metric instead of LTV

   1. This is a much more conservative metric, but when compared to CAC, if your first year margin covers the CAC, you know you’re on the right path

2. Use industry churn metrics instead of company churn metrics

   1. By using industry median metrics, you will come to a more conservative metric