It’s one thing to have a customer base. It’s another thing to have loyal customers. But it takes time, effort, and skill to be able to convert those loyal customers into repeat buyers with high lifetime value (LTV). In this aritcle, you’ll learn about four different ways of calculating customer lifetime value by examining the purchase history of individual customers.
The simple formula
The simple formula is a simple equation that can be used to calculate LTV. Here’s how it looks:
LTV = (1 + Monthly Recurring Revenue Per Customer)(Monthly Recurring Revenue Per Customer).(# of Months)
Let’s break this down. First, you will have to calculate monthly recurring revenue per customer—this figure is also known as the MRR/CAC ratio and measures how much money you make from each customer over one month. It is calculated by dividing your total monthly recurring income by your customer acquisition cost (CAC). If you want an easy way to estimate your CAC, use the “Rule of 40”—40% of the total amount spent on marketing equals CAC for most businesses.
Next, plug these two figures into your equation using this formula:
LTV = (1+MRR/CAC Ratio)(MRR/CAC Ratio).(Number of Months).
The Pareto/NBD model
The Pareto/NBD model is a simple way to calculate CLV. It’s especially useful for companies with small customer bases who may not have enough data available to use other models. The model is based on two principles: the Pareto principle (also known as the 80/20 rule) and NBD (Net Benefit).
The first part of this equation—the Pareto principle—states that 80% of your sales come from 20% of your customers. These high-value customers are also referred to as “superusers.”
Gamma-Gamma is a model that looks at the value of an individual customer and how that changes over time. It’s a great way to measure lifetime value, but it also works well for retention rate and even net present value (NPV).
The formula for Gamma-Gamma is:
Value = 0.5(1 – e^(-k x) + e^(-k x))
In this formula k is the retention rate, usually expressed in decimal form (e.g., 0.95), and x represents the time since the first purchase or sign-up date (in years).
The RFM method
The RFM method is an efficient way to measure customer lifetime value. It looks at three key factors: how likely a customer is to repurchase from you, how likely they are to recommend your product/service/company, and how often they respond to your marketing efforts. The first two metrics give you a sense of the monetary value of each customer, while the third helps you understand how engaged they are with your brand.
The equation for calculating Customer Lifetime Value using this method is as follows:
LTV = [(P x A) + (S x D)] / C
The examples here are just a few of the many ways to calculate LTV. Each method has its pros and cons, but no matter which one you choose, it’s important that you understand what these metrics mean and how they can help your business grow.