The Three Most Common Pitfalls About Customer Lifetime Value
Customer Lifetime Value (CLV) is a powerful metric used to maximize shareholder value. It allows organisations to make smarter decisions, notably on customer acquisition and retention, and pricing. More and more organisations are using the metric, notably e-commerce and SaaS businesses. However, there are many misconceptions about it. Today, we will investigate the three main pitfalls when dealing with CLV. These are:
- Pitfall #1: Not factoring in variable costs
- Pitfall #2: Not accounting for the time value of money
- Pitfall #3: Using a finite horizon instead of an infinite one
Pitfall #1: Not factoring in variable costs
The first pitfall is not factoring in variable costs when calculating CLV, which leads to over-stated values.
I often see articles (this one for example) suggesting to use only revenues for the CLV calculation. This is bad practice for one simple reason: in the long-run, companies are most concerned with their bottom-line, not their revenues (or at least, they should be). Therefore, as a decision-making tool to improve the business, CLV should be based on contribution margin, not just revenues: one simply cannot rely on a CLV number that does not factor in variable costs to infer and/or optimise future profits.
For example, a classic application of CLV is to compare it against the cost of acquisition (CAC), using the CLV-to-CAC ratio. This ratio summarises the unit economics of the company: how much money does it make on every customer balanced against how much does it cost to acquire one. Of interest here is the customer contribution to fixed costs, then profits after all fixed costs have been covered. A “CLV-to-CAC” ratio based on revenues does not paint the full picture and is practically meaningless: such a “CLV-to-CAC” ratio, even very high, begs the question — how much does it cost to serve this customer? Knowledge of an item’s selling price is not enough to assess the item’s attractiveness on a unit basis but knowledge of the item’s contribution margin is. The same goes for a customer.
In the world of start-ups, angel investors and venture capitalists, the magic number for the CLV-to-CAC ratio is 3 for SaaS businesses. In practice, a CLV-to-CAC ratio of 3 means that for every acquisition dollar spent, the company can expect to make a $3 contribution margin before acquisition costs, or $2 after. A CLV-to-CAC ratio below 3 raises serious questions about the unit economics of a SaaS business, that is, its ability to turn a profit. This is because the CLV-to-CAC ratio excludes fixed costs, which can be massive for SaaS businesses.
Pitfall #2: Not accounting for the time value of money
The second pitfall is not accounting for the time value of money, which can lead to vastly overestimated CLV numbers.
Again, many articles (including the article referenced above) fail to include this critical point in their proposed calculation. Just as a dollar in the bank tomorrow is worth less than a dollar in the bank today, a cash flow to be received from a customer tomorrow is worth less than a cash flow received from a customer today. It is imperative to take the riskiness of future cash flows into account, especially for calculations that involve a long time horizon such as CLV.
In the world of finance, accounting for the risk of future cash flows is done through discounting in a Net Present Value (NPV) calculation, which is a mathematical way to decrease the value of these cash flows to tally them up in today’s dollar. That is why CLV is defined as the net present value of future cash flows from a customer.
With yearly discount rates often around 10% or more, it is clear that not accounting for the time value of money can quickly lead to a massive overestimation of CLV. Figure 1 below shows CLV is over-estimated by a colossal 27% (!) when the cash flows are not discounted compared to the correct calculation using a discount rate of 10% per period. The churn rate is 25% per period.
Pitfall #3: Using a finite horizon instead of an infinite one
The third and last major pitfall is using a finite horizon instead of an infinite one. There are two main reasons why people fall into this trap.
The first reason is that calculating, or rather, forecasting CLV is hard. When faced with this harsh reality, many organisations take the easy route and decide to only count the first few months or years of the relationship with their customers, instead of doing a bad job at forecasting the cash flows in the later years of the relationship. By doing so, they assume they will stop making money on all customers by the end of their calculation horizon, which is of course incorrect. As we have seen previously, the correct way to account for uncertainty is to perform a NPV calculation.
Note that in certain situations it can be sufficient, or even make more sense, to make a “CLV” calculation over a finite horizon. For example, over the length of contract if the business setting calls for it. This is common in the world of telecom for example. However, it should be recognized that it is not a CLV calculation, and the resulting number should not be called CLV. I have seen acronyms such as “CCV” for Customer Contract Value or “CXV” with “X” the number of periods taken into account (for instance, C5V for Customer 5-year Value).
The second reason for using a finite horizon is making the mistake of summing the future cash flows to the average tenure only. Typically, people both account for churn, by reducing the expected cash flows every period using a retention rate, and sum to the average tenure. This “double-averages” the calculation and is a mistake. But even excluding the effect of churn and summing to the average tenure does not work. This is because the timing of the cash flows is incorrect, which throws off the discounting calculation. The detailed explanation is a bit long and technical, so I wrote a separate article about it.
Long story short, the correct way to forecast CLV is to directly include the effect of churn in the calculation, and sum the future cash flows to infinity.
Conclusion
CLV is an incredibly valuable metric that companies can (and should) use to improve their business in many ways, for example balancing their acquisition and retention budgets. But it is necessary to get the basics right before relying on it:
- Factor in variable costs,
- Account for the time value of money, and
- Use an infinite time horizon
