Customer Lifetime value is the most confusing of all SaaS metrics. The primary reason behind that is the complexity of calculating it accurately. You have to face various challenges while calculating it. Apart from that, you may repeat some common mistakes that lead to errors.
However, you cannot ignore this metric. To forecast future revenue, it’s crucial to understand how is LTV calculated. Therefore, we are going to tell you how to calculate it accurately. Today, we will not only tell you about the LTV formula but also guide you on how to avoid common mistakes. Let’s move forward without further ado.
How is LTV Calculated?
To calculate these crucial metrics, you can use a simple formula.
LTV = ARPU (average monthly recurring revenue per user) × Customer Lifetime
You can calculate customer lifetime by using the churn rate.
LTV = ARPU / User Churn
From this formula, you can calculate LTV for different customer segments. All you need to do is to track ARPU and churn rate. However, you can obtain accuracy only by avoiding common mistakes.
Mistakes to Avoid When Calculating LTV
Overlooking Cohorts
Not all customers contribute equally to the revenue. A common mistake is treating them the same when calculating LTV. High-value customers often make frequent purchases, while others may only buy occasionally. Therefore, you should make cohorts based on various factors, such as purchasing behavior, demographics, or engagement levels. As a result, you can get a more accurate and clear LTV for each group.
Ignoring the Time Value of Money
It’s one of the most common mistakes that many businesses make and they don’t even know about it. Future revenue will not be as valuable as the money you receive today, especially due to the devaluation of money and inflation. When calculating LTV, it’s important to discount future cash flows to their present value. Otherwise, you will overestimate LTV, which could lead to spending more on customer acquisition and retention.
Assuming Constant Behavior
Many businesses assume that customer behavior will be the same over time. However, such cases are very rare. Customers’ needs and preferences often change due to varying circumstances and market trends. If you base your LTV on the assumption that customers will always behave the same, your calculation will not be accurate. You should regularly update your calculations to reflect changing customer behaviors.
Neglecting Churn
It doesn’t matter what business you own, churn is inevitable. You cannot reduce it to zero. All you can do is develop different strategies to control it. As discussed in the formula, churn is a critical element in LTV calculations. A mistake that businesses often make is either underestimating or ignoring the impact of churn. This can lead to an inflated LTV, giving you an unrealistic view of profitability. It will ultimately lead to poor strategic decisions.
Relying Only on Historic Data
Historical data is valuable for calculating customer lifetime value. However, it shouldn’t be the sole factor you rely on when calculating LTV. Markets and trends change over time. It means what worked for your business in the past may not work in the future. Therefore, you should incorporate predictive analytics and consider future trends. It will help you create a more accurate future-proof LTV model.
Simplifying Calculations
Simplified LTV formulas make it easy to calculate LTV. However, they often miss important details. For instance, you may use basic formulas that don’t consider factors like customer acquisition costs, churn, or multiple revenue streams. This approach can give a quick snapshot. However, it often leads to inaccurate results that don’t reflect the actual value of your customers.
Not Adding Variable Costs
Many businesses focus on revenue when calculating LTV. However, they forget to subtract variable costs associated with serving customers, such as shipping, customer support, or production expenses. These costs can significantly reduce the profitability of a customer. So, you need to exclude them from LTV calculations to figure out how much value your customers bring.
Not Considering Customer Lifetime
Some businesses assume that customers will stick around forever. They often use long time frames, such as five or ten years for LTV calculations. However, it should be based on actual data regarding how long customers typically stay with your company. If you overestimate customer lifetime, you may end up with figures that don’t reflect reality.
Leverage Baremetrics to Master LTV Calculations
Calculating customer lifetime value manually can be overwhelming. You have to track different metrics and then use them to calculate LTV. You can leverage Baremetrics to calculate it without any hassle. It’s a powerful tool with advanced features to track various SaaS metrics. You can rely on it to not only track but analyze metrics to get valuable insights. Sign up now to get a free trial.