Are you doing LTV wrong?
“Customer Lifetime Value (CLV) is about the future, so we should invest big now.” Heard in a client meeting last week. Err… kinda…
To her credit, she used it as an example of how CLV can be misused to justify overspending on marketing.
To use the CLV framework appropriately for marketing investment, consider the following:
Margin vs Revenue: In CLV calculations, contribution margin is key. Relying solely on revenue can lead to overestimating CLV. For example, with a 50% margin, CLV is doubled, while a 20% margin results in a 5X margin-based CLV. Take a simple example: $200 monthly revenue over 24 months totals $4,800. At a 50% margin, the contribution margin is $2,400 over 24 months.
Lifetime value without considering probability: Assigning probabilities to future transactions and retention is vital for accurate CLV estimation. Using the same example of $100 contribution margin per month, applying a 5% monthly drop-off over 2 years, without it, the estimate is $2,400. However, with the drop-off, the value reduces to $1,416, overestimating by ~70%.
Discounting future cashflows: Apply the financial principle of discounting future cashflows to account for the time value of money. Over a 2-year period, the overestimation aligns roughly with the discount rate. For instance, a 20% annual discount rate results in a 20% overestimation without discounting.
Combining the factors: In this example, the discounted and probabilized future cash flow (margin) amounts to $1,315. Compared to the initial estimate of $4,800, this overestimates CLV by a significant 265% (or 3.65X)!
Simplification frameworks exist, such as CLV vs CAC ratios like 3:1 or 5:1, commonly used in venture capital. However, understanding underlying assumptions and adjusting them is essential. In this numerical example, a 3:1 ratio wouldn’t break even, and a 5:1 ratio leaves little margin for error.
By understanding the factors involved in CLV calculations, businesses can make informed marketing investments aligned with their goals. Matching the right CLV definition to its use prevents reckless overspending. A grounded understanding of CLV allows for optimised marketing efforts, maximising long-term profitability, and ensuring success in the evolving business landscape.
