The Life Time Value is a prediction how much gross profit a company can generate from an average customer. It essentially applies a perpetuity formula to the gross profit per customer by dividing it with the customer churn rate. If this figure is significantly higher than the cost to acquire such a customer, unit economics will be positive and the company will be more likely to drive a sustainable net profit.
While this sounds simple enough and it is widely repeated in similar summarised versions across the internet, what are actually the inputs to this formula?
First, we need to be clear about the fact that the inputs need to be for the same period. Gross Profit is relative to a period and so is the churn rate. As startups typically count in months (for reporting but also financial models), we look at Gross Profit per Customer PER MONTH and hence the Churn Rate also needs to be PER MONTH. Also, let’s be clear, churn rates come in many different varieties. A churn rate can be called a “drop-off rate” or how many customers stop being customers every month. We have a separate section on churn rates but for now just be aware we are looking at a monthly customer reduction as percentage of total customers here.
Secondly, what is gross profit per customer? Gross profit is Revenue minus any Variable Cost of Sales. So for example transaction fees etc. Also Revenue should be net off any discounts or vouchers given to your customers to arrive at a true Life Time Value.
Thirdly, given that a customer usually doesn’t buy exactly one unit of your product or service per month, we should define gross profit per unit (e.g. per booking at a food delivery app or per product your company sold) and multiply it times the average number of units sold per customer per month.
So with our more detailed knowledge of Life Time Value, the above formula now looks as follows:
If there is no expected growth in your gross profit margin, this simply is the gross profit for a revenue unit per period, divided by the churn rate (or customer drop off rate) per your defined period (usually per month).
Example: Food Delivery App
Using our example of food delivery apps, if an average order, after all discounts and payments to the restaurant, renders 2 dollars in gross profits and an average repeat customer makes 5 bookings per month, and 2% of the current customer pool stops using the service at each month end, then the life time value of an average customer is $2.00 times 5 divided by 2%, which equals $500.00.
Life Time Value with growing Gross Profits
If your gross profits themselves increase on a regular basis, then you might subtract that growth rate from the churn rate.
And with our more detailed version of the Life Time Value formula, incorporating growing gross profits would look as follows:
If this feels unintuitive you could compare this to the Gorden growth method which you might have heard about in relation to Terminal Value calculations where you also deduct the growth rate of cash flows from the denominator. Simply put, the smaller the percentage based denominator, the larger the result. So if your churn gets smaller, or you deduct a relatively large growth rate of Gross Profits, your Life Time Value increases.
But please note that we are talking about monthly periods here and any exponential growth on such short time periods has a dramatic effect. Also, these margins likely don’t increase too much, or at least not forever. So most commonly you would assume NO growth and account for any changes to Gross Profit by way of changes to the inputs to gross profit, and likely you would do this very sparsely – maybe an incremental change per year in your financial model assumptions.
Example: Food Delivery App – with Gross Profit Growth
Let’s say however Gross Profits do increase by 0.1% per month, the result would be US$2.00 times 5 bookings divided by 2% minus 0.1% which would equal to US$526.32.
Table of Contents