A Primer on Customer Lifetime Value
Once, whilst collecting my coffee, I accidentally spilt it all over the counter. It was ultimately my fault - but they did not hesitate to make me a new one straight away. And without charge, even if it’s technically within their rights to do so. It really wouldn’t make much business sense if they did, right? Because coffee is something I drink every day, the marginal cost of making a new one is almost zero, and if I was asked to pay I might feel unvalued and go elsewhere. What’s really at stake is the £1000+ I spend on coffee annually, not the drink I just spilt. Good companies recognise that all it takes is a single bad experience to wipe out your customer loyalty, whilst good experiences create lasting impressions which keep you coming back for more. If anything, the kindness I experienced made me more likely to continue buying my coffee from there in the future.
It’s all very intuitive, but it’s still widespread to treat customers as transactions rather than relationships1. Even at large companies that should know better, there can be a tendency to go from campaign to campaign, racking up short term wins that lack sustained returns over time. One reason for this is that it is harder to neatly capture long term value in a KPI. And it can be a cultural problem that goes well beyond the practices of, say, the performance marketing team, as companies try to maximise their next set of quarterly earnings.2
But there is one metric that hopefully all marketers are familiar with (even if you’re not using it), one guiding beacon in the fog of short-termism: Customer Lifetime Value. Let’s call it CLV from now on.
What is CLV?
There are multiple variations of CLV depending on the nature of the business3 and it is more of a concept than a formula, but it is essentially the present value of customer future cash flow over a time horizon, which can be either a defined period or the average retention time. Taking the latter definition, a crude measure of CLV would then be average order revenue x average order frequency per year x average retention time in years. It can be developed into a net figure by subtracting the fixed customer acquisition cost (CAC) and the yearly cost of customer retention (CRC). Beyond this ‘descriptive’ approach, we can deploy statistical modelling which enables us to use other leading indicators - think acquisition channel, demographics, new product launches - to generate a more nuanced forecast of CLV.4
What are the applications of CLV?
Fundamentally, you want to spend less on acquiring customers than you think they are worth over their lifetime. How much less? VCs typically look for a minimum 3:1 CLV:CAC ratio5, which suggests a good product-market fit and a company that is growing sustainably, whilst possessing the potential to scale with minimal outside investment. Note that this ratio typically refers to gross CLV, so in industries such as retail where the gross profit margin is relatively low, this ratio should be higher.
3:1 is a considerable buffer, and if your profit margins are high it may be tempting to cut it closer. However, there are drawbacks to this. Firstly, CLV is a forecast with inherent risk. It is almost certainly wrong; you just have to hope it isn’t too wrong. Secondly, more aggressive campaigns in a finite market will increase the cost of acquisition and likely attract worse customers6, and you might be surprised how quickly CLV and CAC start to converge toward each other. And then you’ve thrown half your budget into marketing, whilst your competitor has been ruthlessly improving their customer experience and acquiring customers that way. Your customers probably - the ones you were banking on to deliver value in the future. Put simply, your efforts may be better placed increasing the ratio by improving CLV, rather than trying to make money through arbitrage.
Another application of CLV is in informing customer retention efforts. Low CLV customers might be one-off customers that didn’t spend again, and/or markdown chasers. They tend not to give you much return for marketing spend (although shouldn’t be discounted entirely with the right tailored reactivation campaign). High CLV customers, meanwhile, can generate a lot of additional value from loyalty schemes and personalised campaigns. As with looking at CAC, it is best to segment CLV across dimensions like demographics, acquisition channel and so on to create holistic customer profiles.
One valid criticism of CLV is that it doesn't fully encompass the entire spectrum of customer value. This perspective highlights factors like the network effects stemming from swiftly expanding market share, or the role of advocate customers in attracting new customers.7 Mobile games are a particularly interesting example of this. They often have CLV:CAC ratios below 1:1, as more users enable them to scale app charts and acquire future customers at very little cost. And I personally miss the glory days of the millennial lifestyle subsidy, when the ‘era of free money’ enabled tech companies to ruthlessly acquire customers at almost any cost. But that era is over, and we all have to make peace with never seeing single digit Uber fares again in our lifetimes.8
I intrinsically love CLV, it’s a long term metric in a world of short term thinking. But that’s sort of the problem right there - it gets used by marketers as a way to pretend a short term decision was really a long term one. Ultimately, there are thresholds where the incremental benefit of increasing marketing spend is too valuable to turn your nose at, and marketing should always be some percent of your budget. But this shouldn’t come at the cost of a stagnating or declining CLV, as it’s a slippery slope from there. Focus your efforts on improving CLV and it’s hard to go wrong. And that means seeing CLV not solely as a marketing KPI for the purpose of keeping CAC in check, but something that energises the whole business to deliver value for customers.
Case in point - a loyal customer stops going to their regular lunch spot over $0.07.
In 2020, the CFA Institute estimated the cost of short-termism as $79bn a year in lost earnings for S&P 500 companies. BlackRock CEO Larry Fink, in his 2019 letter to CEOs titled Purpose & Profit, warned of the increasing tendency for corporations to maximise short-term returns during periods of uncertainty at the expense of long-term growth.
Essentially whether customers repurchase (e.g. e-commerce) or churn (e.g. SaaS).
Many CRM tools come equipped with pre-built models that you can input your data into, enabling you to generate CLV forecasts quickly. For a more custom approach, here are a few papers on approaches to forecasting CLV in B2B SaaS and B2C e-commerce.
VCs will typically want to see this aggregate broken down by segments such as region and acquisition channel.
Acquired customers typically have a lower CLV than organic customers, and you shouldn’t expect their CLV to stay constant as you increase marketing spend.
I am planning to do a deeper dive into measuring customer (dis)advocacy in a future post. The basic CLV formula does not capture advocacy explicitly, and even if you segment CLV on Net Promoter Score or include it as a regressor, the true value of advocates is in driving new customers and building brand awareness. Of course, they could just as easily be writing bad reviews and driving customers away. If you had a good referral system, this may be easier to track at least on the upside.
These subsidies were not just demand side, as Uber used billions of investor dollars to attract drivers, and with it a large enough car pool to offer an instant service to customers and dominate regional taxi markets. Some drivers report making as little as a third of what they made when subsidies were in place.