Ever wondered which customers cost you more than they bring in? Or how successful your loyalty strategies really are?
You’ve probably heard it many times: retaining existing customers is significantly easier — and often cheaper — than acquiring new ones. Research shows that, in small businesses, repeat customers tend to spend 67% more than first-time buyers.
So, it’s important to know two things: which customers are worth spending money on and how to keep them coming back. And to help with that, we’ll turn to the customer lifetime value metric.
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What is Customer Lifetime Value (LTV)?
Customer lifetime value (LTV) is a metric that shows how much revenue you can expect from a typical customer over their relationship with your company.
LTV becomes very useful when compared across different customer cohorts or segments and against the cost of acquiring those customers.
The goal is to identify which customers are the most valuable and understand why.
What is the difference between CLV and LTV?
Before we jump to calculations, let’s clarify the terminology. You might have encountered initialisms like CLV, CLTV, and LTV, which are often used interchangeably.
But there is a difference, and this difference lies in granularity.
- CLV (or CLTV) refers explicitly to the lifetime value of a single customer or an individual account.
- LTV, on the other hand, refers to the lifetime value across multiple customers, such as a customer segment or the entire customer base of a company.
In essence, CLV is a more detailed view of the same metric. Throughout this article, I’ll use the LTV definition when referring to customer lifetime value.
How to calculate LTV?
For better or worse, there are multiple ways to calculate LTV.
To illustrate the concept, we’ll focus on a simple approach that looks only at revenue. However, more complex calculations might incorporate profit margins and different operating expenses.
So, here’s the formula:
LTV = [Average Order Value] x [Average Number of Orders] x [Retention Period]
Here, the first two elements make up the revenue generated from purchases. The retention period (also called customer lifespan) measures the time customers continue buying from your company.
Note: you must be consistent in the time period used for both the average number of orders and the retention period.
Depending on your industry, you’ll typically choose between months or years. For instance, customers at a coffee shop might visit several times a month, whereas a car dealership might see buyers return much less frequently, extending the timeline to several years.
LTV example
Imagine you own two car washes — one near an airport and another in a residential area.
Both locations offer a single car wash programme priced at $10. In such a case, the average order value is also $10.
The airport location primarily attracts tourists washing their rental cars before returning them (no one wants to get charged an enormous fee for returning a dirty car!). Here, an average customer makes just 2 visits over 2 years.
Therefore, the LTV would be:
LTV = [$10 average order] x [2 visits] x [2 years] = $40
On the other hand, at your residential location, customers frequently stop by on their way home. A typical customer makes 40 visits and tends to keep coming back for 5 years.
In this scenario, the LTV would be:
LTV = [$10 average order] x [40 visits] x [5 years] = $2,000
As you see, LTV factors in both revenue and customer retention. The longer — and more frequently — customers continue to purchase from your business, the higher their lifetime value becomes.
That is the beauty of the metric: it reflects how good you are at keeping your customers loyal.
Why LTV matters?
Now that we’ve covered how to calculate LTV let’s see why it’s important.
There are three main areas where LTV can help:
1. Marketing strategies
When you know the LTV of your typical customer, you can estimate how much you can spend on acquiring new ones.
Comparing LTV with Customer Acquisition Cost (CAC) is commonly used to measure customer profitability. If LTV exceeds CAC, it usually suggests that your marketing efforts were worthwhile.
Continuing with our example, say you’ve allocated the same advertising budget to both your airport and residential car wash locations, resulting in a CAC of $80 at each site.
It means you’re spending $80 to attract customers who bring in either $40 or $2,000 in revenue. Clearly, the investment at the airport car wash isn’t paying off, while it’s highly profitable in the residential location.
Apart from the LTV to CAC ratio, a cohort analysis can reveal which marketing campaigns were more effective over various periods. Customers are placed into groups (or cohorts) and analysed by week, month, or year.
2. Customer retention
Customer loyalty and satisfaction are often measured using Net Promoter Score (NPS) and Customer Satisfaction (CSAT). However, I’d argue that customers truly show their loyalty with their wallets.
While NPS and CSAT are important, LTV measures the direct impact on revenue, making it an objective indicator of customer retention.
If you notice a change in LTV, you can proactively enhance customer value, for example, by tweaking a rewards program, gathering customer feedback, or both.
Therefore, I suggest tracking LTV alongside other loyalty metrics to identify and address any issues with customer retention early.
3. Forecasting and planning
Forecasting revenue accurately is hard.
However, LTV provides insights into potential revenue streams so that it could be a valuable input in your revenue and cash flow forecasts.
When raising finance, investors and lenders typically request your financial projections. A detailed revenue forecast, supplemented by LTV data, can help demonstrate the business’s growth prospects.
Also, revenue forecasts can guide budgeting decisions and resource allocation within your financial planning cycle.
To sum up
With all that said, LTV is a confusing metric — not just because there are many ways to calculate it but also because collecting and organising data can be complex.
To effectively track LTV over time, you’ll likely need to automate data collection, and many modern analytics solutions can significantly simplify this process.
But to get started, you can simply use a spreadsheet to calculate that magic number to take action straight away and improve your marketing and retention strategies.
