Customer lifetime value (LTV) is an estimate of the average revenue a customer will earn for a company over the entire length of the relationship. It's an important metric that plays a critical role in optimising revenue and profits, because it's an important part of calculating the unit economics of a business. It should be considered when estimating budgets, forecasting cash flow, determining valuation, and increasing profitability.
Want to know more about LTV? Then keep reading to get an in-depth understanding of how it can help your business.
What is LTV?
Lifetime Value of a customer is a measure of how much revenue a company is estimated to make from a customer over their relationship.
How to calculate LTV?
LTV is calculated by dividing monthly average revenue per user (ARPU) by the percentage Churn in monthly recurring revenue (MRR Churn).
For example, if a SaaS company’s ARPU is $25 for a month, and the monthly MRR Churn is 5%.
Then its LTV will be
This example shows us the company can anticipate earnings of $500 from each customer it acquires.
Calculating LTV using discount rate
The formula mentioned above fails when monthly MRR Churn is zero since it is impossible to divide any number by zero. Although negative MRR Churn is good for business, it gives a negative LTV – which is not a reflection of the company but a limitation of the formula when being used for strategic financial planning. Moreover, it does not consider the time value of money. Thus, the formula provides misleading results with negative MRR Churn.
For example, observe the following scenario –
LTV is the same for both companies. However, company B’s ARPU is more than that of company A. Hence, company B will recover cash from its customers more quickly.
These issues will be resolved by using a discount cash flow rate while calculating LTV, as it will compensate for the time value of money. However, this is a tedious process. Avoid it unless your organisation has extremely low or negative MRR Churn. David Skok wrote an excellent guide on this for anyone facing these issues.
Strategic Financial Planning with LTV
Need better tools to help you with strategic financial planning? We are currently offering a free SaaS financial model template to help SaaS organisations benchmark their valuation, LTV, MRR, ARPU, and other metrics against 200 VC-funded private companies in the Bessemer Venture Partners portfolio. Click here to access the free SaaS metrics valuation benchmarking template.