Customer lifetime value (CLV) is a key metric for understanding how to best invest your resources. It measures the net present value of all future revenues from a customer, plus any additional profits associated with those revenues such as operating expenses or investment returns. But to understand what customer lifetime value is and how to calculate it, you first need to understand the different types of CLV models. In this article you’ll be introduced to three important CLV models that will help you make better decisions:
The discounted cash flow method
The discounted cash flow method (DCF) is a framework for calculating the present value of an investment based on its projected future cash flows and the cost of capital. The discount rate, also known as the required rate of return or cost of equity, is determined by weighing all relevant factors such as industry risk and general market conditions. Estimate the rate at which you would expect to earn money by investing in a similar project with comparable risk, adjusted for the company’s unique characteristics.
The basic CLV model
The basic CLV model, which is also known as the acquisition and retention model, calculates customer lifetime value by dividing the total revenue by the number of customers at any given point in time. The resulting number represents the average customer lifetime value for a business over a specified period.
The basic CLV models provides a useful benchmark to compare your company’s performance against competitors or industry trends. Also, it allows you to evaluate different marketing strategies based on how they impact CLV over time. If an advertising campaign results in more new customers but fewer repeat customers than before, then it may be worth reconsidering that particular strategy because it’s not driving CLV growth as well as expected—or possibly even reducing it.
The Pareto/NBD model
The Pareto principle states that 80% of a business’s revenue is generated by 20% of its customers. By using this principle, you can focus your efforts on attracting and retaining high-value customers who will generate more revenue for your company in the long run.
To use this model, you’ll need two metrics: ARPU and customer lifetime, also known as NBD or net bookings per dollar. ARPU refers to average revenue per user; it shows how much money each customer brings in over their lifetime as compared with other new users or existing customers. Customer lifetime shows how long a customer stays with your company before canceling service or being lost due to churning (switching providers).
By knowing the lifetime value of your customers, you can better understand how to best invest your resources. If a specific group of customers is spending more money than others, it might make sense to devote more of your marketing efforts towards that group because they’re likely to provide a greater return on investment.
Also, these metrics can help you understand where improvements are needed for you to increase profits and stay competitive in the marketplace. If some types of customers stay longer than others before buying again, this may indicate that their experience was underwhelming—and so perhaps it’s worth considering changing tactics or adding features to retain them for longer (and ultimately make more sales).
Conclusion
Don’t get too caught up in which method is best; instead, focus instead on what kind of information each one gives you about customers, how they interact with your business, and how much money they bring in over time. Look at CLV from many angles—customer acquisition cost (CAC), customer lifetime profits (CLP), lifetime value per customer (LVC), etc.—and think about which ones make sense for your industry or product line. Also, don’t forget about other metrics like conversion rate (CR) or churn rate (CR) that show how effectively you are retaining existing customers.