What is customer lifetime value (LTV) and how to calculate it

Cliff Hanger, the CEO of a rising media agency, wore a frown as he spoke those words while entering the boardroom with a cup full of black coffee. His Tuesday hadn’t started in the manner he had hoped for. Not only did he not find his usual parking spot, but he was also just given some drastic news by his CFO that had forced him to call an emergency meeting.

“We could do that in many ways,” said Miranda, the Revenue Manager. “But my advice would be to increase our customer LTV by increasing our ARPA.”

The top executives were discussing the future of the business. Something that would involve amending a few vital strategies and would impact sales, revenue, and most importantly their customers.

“Won’t reducing the churn also work well?” asked Kurt, the Marketing Manager. 

His team had been working hard for the last couple of months to brainstorm ways in which they could keep customers from leaving. The team even came across a valuable churn study and was excited to present their findings later that week.

Tim, the aspiring new recruit fresh out of business school, had also read that book. It was called Marketing Metrics. He was hired to do basic marketing stuff but had been asked to sit in these financial strategy meetings by Kurt, his manager.

“Ah, so by upselling to our existing customers we can increase the MRR, which would then increase the ARPA, which would then increase the customer LTV. That’s brilliant Miranda,” said Cliff jubilantly as his guzzled the last of his coffee down.

Just like any other person who is not a financial wizard and does not have any inclination towards those complex financial jargons, Tim was now completely lost. 

“What the heck are these guys talking about?” he asked himself while sitting at the very end of the boardroom. He knew that agencies had a tendency to use three-letter acronym (TLA) terms very liberally, but this was getting out of hand.

“Should I be throwing in a couple of TLAs of my own?” he wondered. “Customer LTV maybe? After all that is the theme of this meeting. I better Google some stuff before speaking though,” he thought.

Wise move, Tim. Wise move.

What is Customer LTV?

A quick Google search took Tim to the Economic Times website that defined customer lifetime value (LTV) as: 

“The present value of the future cash flows or the value of business attributed to the customer during his or her entire relationship with the company.”

“Hmm, that does not clear things up,” Tim scoffed. A more detailed search, however, gave him a much clearer understanding.

Doesn’t seem too complex now, does it?

“But why do companies care how much value they can get out of a customer? Isn’t the monthly recurring revenue (MRR) the only metric worth keeping a track of?” wondered Tim, recalling the story of Penny and her tryst with MRR. 

At least there was one TLA that he was comfortable floating around. He did another quick Google search to find out more about the importance of customer LTV.

Why is Customer LTV important?

The primary reason that customer LTV is important is because the metric helps companies put things into perspective with regard to managing their business spends and becoming more profitable.

Tim felt much more connected to the research he was doing this time around because it involved a lot of familiar terms. For example, he came across a metric called customer acquisition cost (CAC) that companies considered critical in relation to the customer LTV.

He remembered one of his marketing professors mentioning how the costs associated with sales and marketing are important because they contribute directly to the cost of acquiring a customer.

“Okay. But why does the CAC keep coming up when I’m searching for the importance of customer LTV?” wondered Tim while feeling proud of himself for using two TLAs together.

Read on, Timmy boy. Read on.

The reason why CAC and customer LTV are almost always talked about in tandem is because, for an organization to sustain itself, it must implement a profitable business model. And to do so, it must always ensure that its customer LTV is higher than its CAC.

“Ah ha!” exclaimed Tim. 

The conversation between Cliff, Miranda, and Kurt earlier had suddenly started to make sense. The customer LTV: CAC ratio for the company had fallen below the desired mark and hence the emergency meeting was called.

“But how low could the ratio have fallen? If only there was some way for me to calculate the customer LTV and find out myself.”

And there went Tim. On yet another quest to search for more answers.

How to Calculate Customer LTV?

Tim found out that to calculate the customer LTV you must take the average revenue per account (ARPA) and divide that number by the customer churn rate.

To further understand how to calculate the customer LTV and its dependent variables, Tim studied an example:

How to Increase Customer LTV?

Looking at all the research where he deciphered what customer LTV is and figured out how to calculate it, Tim finally understood what Miranda and Kurt were talking about earlier.

If the aim of a company is to increase its customer LTV, it can do so in two primary ways:

• The Miranda Way (increase the ARPA)

This method is as simple as devising strategies to increase a company’s monthly recurring revenue, which would consequently lead to an increase in the ARPA. How must one do that, you ask? That’s the puzzle that every strategist is tasked to solve. 

What Miranda was suggesting was increasing revenue by upselling to existing customers since research indicates that businesses have a 60-70% probability of selling to existing clients as opposed to  a 5-20% probability of selling to a new one.

• The Kurt Way (reduce churn)

Kurt, on the other hand, was suggesting to reduce the customer churn rate, which would in turn help the company lessen their client turnover and ultimately increase revenue.

Apart from the fact that Kurt was his boss, Tim felt more inclined towards this method because it promised to increase the customer LTV and elevate the company’s brand equity in the long run. Thinking like a customer, while giving them reasons to not leave, is what builds a company’s reputation and leads to a win-win situation for all parties.

Tim realized that for a company to get the desired value from its customers, it must provide them with the desired value as well. If someone was losing interest or had stopped engaging with the service/product, there was a good chance that the customer LTV would decrease. Furthermore, based on the churn study that the marketing team had recently acquired, Tim was also looking forward to devising strategies that would reduce churn and help the company grow.

Gazing at all the people present there, he knew the answer to Cliff’s question now. What started out as a hauntingly taxing meeting was now looking more relaxed and fun. “If I may interject, I think there is a better way for us to increase our customer LTV,” Tim said interrupting everyone. 

The group, which had already moved on to discuss last night’s football game, looked shocked. Tim looked at everyone staring back towards him. All eyes locked on his.

“Go ahead, Tim. What do you have for us?” enquired Cliff. 

Sitting quietly at the back of the boardroom, this is what he had spent the last 15 minutes researching about. This was it. This was the moment. This was Tim’s time to shine.