Customer Lifetime Value Formula (CLTV) Explained
Are the margins from your customers paying off your customer acquisition costs? By what factor? If you don’t know this, keep reading and I’ll explain how I apply customer lifetime value (CLTV) and CAC in my financial analysis and walk you through the customer lifetime value formula.
My Excel Template Can Be Downloaded Below
What is the Customer Lifetime Value Formula?
Depending on how you calculate CLTV, it can mean many things. Below is the formula I use to calculate CLTV. For me, this formula produces the lifetime margin (factors in ACS) of one customer after discounting for the time value of money (WACC) and churn but offset by customer subscription growth. Pretty wordy, I know. Think business valuations. You are valuing the cash flows produced by a customer.
What is a good CLTV?
Is $5K good? $50K? $100K? In isolation it is hard to say and depends on other factors in your business. To make it more meaningful, it’s time to introduce the CLTV/CAC ratio.
What is the CLTV/CAC Ratio?
CLTV is more meaningful when compared to your CAC (customer acquisition costs). For example, if it takes $10K to acquire one new customer and your CLTV is $10K, you’ve got trouble. Meaning, you made no money off this customer. Experts in the field such as David Skok suggest a 3 to 1 ratio on CLTV/CAC. For every dollar of customer acquisition cost (CAC), you should be returning $3 of customer lifetime value.
I view CLTV/CAC as the return on your customer acquisition investment.
If CAC is new to you, CAC is simply the sales and marketing expense spent on acquiring new customers divided by the number of new customers acquired. You can read more about customer acquisition costs (CAC) in my previous post.
To calculate CLTV in my example, you will need your ARPA (average recurring revenue per account), ACS (average cost of service per account), WACC (weighted average cost of capital), dollar churn percentage, and average dollar percentage growth per customer. This is the version that I use, but there are many versions out there. If this formula doesn’t strike a bell with you, try some other variations noted in the resource section below.
In my template, I also include sensitivity tables to understand how changes in two variables affect the customer lifetime value formula.
Why I Like CLTV/CAC
Simply put, you don’t want to spend more on customer acquisition than the lifetime margin of that customer. Just like net margins, you want an increasing CLTV/CAC ratio.
Things to Consider
This is a point in time calculation. Meaning, next month your numbers will be different based on the performance of your business. That’s where cohort analysis comes into play. This month, your CLTV could be $20K and your CLTV/CAC ratio of 1.5, and next month it could better or worse. Let’s hope for better. Most likely your WACC remained constant but you improved your churn rates and your account executives grew the existing customer base at a better rate. In that case your metrics would improve.
If you would like to read more advanced posts on this topic, David Skok has a great post here on customer lifetime value. David Key also has a great post that takes you from a basic CLTV formula to an advanced CLTV calculation.
There are many SaaS metrics out there, but CLTV and CAC are metrics that I would be measuring to understand the unit economics and the health of your SaaS business. Please post your comments and feedback below.
Next week, I’ll be at a continuing education class on measuring corporate performance and creating financial statement models and forecasts. I look forward to sharing what I learn with you when I return.
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