Definition
Customer lifetime value (CLV), lifetime customer value (LCV), or user lifetime value (LTV) is the dollar value of a customer relationship, based on the present value of the projected future cash flows from the customer relationship.
Customer equity is simply the total combined CLVs for all of a company’s customers.
Customer lifetime value encourages firms to shift their focus from quarterly profits to the long-term health of their customer relationships. Customer lifetime value is an important number because it represents an upper limit on spending to acquire new customers.[1]
Purpose
The purpose of the customer lifetime value metric is to assess the value of each customer. As Don Peppers and Martha Rogers are fond of saying, “Some customers are more equal than others.”[2]
Customer lifetime value (CLV) differs from customer profit or CP (the difference between the revenues and the costs associated with the customer relationship during a specified period) in that CP measures the past and CLV looks forward. As such, CLV can be more useful in shaping managers’ decisions but is much more difficult to quantify.
While quantifying CP is a matter of carefully reporting and summarizing the results of past activity, quantifying CLV involves forecasting future activity.
Customer lifetime value (CLV): The present value of the future cash flows attributed to the customer relationship.
Present value is the discounted sum of future cash flows. We discount (multiply by a carefully selected number less than one) future cash flows before we add them together to account for the fact that there is a time value of money. The time value of money is another way of saying that everyone would prefer to get paid sooner rather than later and everyone would prefer to pay later rather than sooner. The exact discount factors used depend on the discount rate chosen (10% per year as an example) and the number of periods until we receive each cash flow (dollars received 10 years from now must be discounted more than dollars received five years in the future).
The concept of CLV is nothing more than the concept of present value applied to cash flows attributed to the customer relationship. Because the present value of any stream of future cash flows is designed to measure the single lump sum value today of the future stream of cash flows, CLV will represent the single lump sum value today of the customer relationship. Even more simply, CLV is the dollar value of the customer relationship to the firm. It is an upper limit on what the firm would be willing to pay to acquire the customer relationship as well as an upper limit on the amount the firm would be willing to pay to avoid losing the customer relationship. If we view a customer relationship as an asset of the firm, CLV would present the dollar value of that asset.
One of the major uses of CLV is to inform prospecting decisions. A prospect is someone whom the firm will spend money on in an attempt to acquire her or him as a customer. The acquisition spending must be compared not just to the contribution from the immediate sales it generates but also to the future cash flows expected from the newly acquired customer relationship (the CLV). Only with a full accounting of the value of the newly acquired customer relationship will the firm be able to make an informed, economic prospecting decision.
Construction
When margins and retention rates are constant, the following formula can be used to calculate the lifetime value of a customer relationship:
Customer lifetime value ($) = Margin ($) * (Retention rate (%) ÷ [1 + Discount rate (%) – Retention rate (%)])
The model for customer cash flows treats the firm’s customer relationships as something of a leaky bucket. Each period, a fraction (1 less the retention rate) of the firm’s customers leave and are lost for good.
The CLV model has only three parameters: (1) constant margin (contribution after deducting variable costs including retention spending) per period, (2) constant retention probability per period, and (3) discount rate. Furthermore, the model assumes that in the event that the customer is not retained, they are lost for good. Finally, the model assumes that the first margin will be received (with probability equal to the retention rate) at the end of the first period. The one other assumption of the model is that the firm uses an infinite horizon when it calculates the present value of future cash flows.
Under the assumptions of the model, CLV is a multiple of the margin. The multiplicative factor represents the present value of the expected length (number of periods) of the customer relationship. When retention equals 0, the customer will never be retained, and the multiplicative factor is zero. When retention equals 1, the customer is always retained, and the firm receives the margin in perpetuity. The present value of the margin in perpetuity turns out to be the margin divided by the discount rate. For retention values in between, the CLV formula tells us the appropriate multiplier.
References
- ^ Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; and David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance (Second Edition). Upper Saddle River, New Jersey: Pearson Education, Inc.
- ^ Peppers, D., and M. Rogers (1997). Enterprise One to One: Tools for Competing in the Interactive Age. New York: Currency Doubleday.