How can you value a service-based business based on customer retention?

1 Customer retention metrics

Customer retention metrics measure how well you keep your existing customers over a period of time. The most common ones are customer retention rate (CRR), customer churn rate (CCR), and customer lifetime value (CLV). CRR is the percentage of customers who stay with you at the end of a period, CCR is the percentage of customers who leave you during a period, and CLV is the net present value of the future cash flows from a customer. These metrics can help you assess the quality, stability, and profitability of your customer base.

3 Valuation methods

There are two main methods to value a service-based business based on customer retention: the income approach and the market approach. The income approach uses the discounted cash flow (DCF) model to estimate the present value of the future cash flows from the business. The market approach uses the comparable company analysis (CCA) or the precedent transaction analysis (PTA) to estimate the value of the business based on the multiples of similar businesses. Both methods require assumptions and adjustments to account for the specific characteristics and risks of the business.

4 Valuation challenges

Valuing a service-based business based on customer retention is not a straightforward task. There are several challenges and limitations that you need to consider. First, customer retention metrics and multiples may vary depending on the industry, business model, and customer segment of the business. Second, customer retention metrics and multiples may not capture the full potential and value of the business, especially if it has other sources of revenue, growth, or competitive advantage. Third, customer retention metrics and multiples may change over time due to external factors, such as market conditions, competition, and regulation.

5 Valuation tips

To overcome the challenges and limitations of valuing a service-based business based on customer retention, here are some tips that you can follow. First, use multiple customer retention metrics and multiples to get a range of values and check the consistency and accuracy of your assumptions. Second, use both the income approach and the market approach to cross-validate your results and incorporate different perspectives and scenarios. Third, use qualitative and quantitative data to support your valuation and explain the drivers and assumptions behind your customer retention metrics and multiples.

6 Valuation examples

To illustrate how to value a service-based business based on customer retention, let's look at two examples. The first example is a SaaS (software as a service) company that has a CRR of 90%, a CCR of 10%, a CLV of $10,000, a RPC of $1,000, a CAC of $500, and a CPP of 6 months. Using the income approach, we can estimate the DCF of the company by projecting its future revenue, expenses, and cash flows based on its customer retention metrics and applying a discount rate. Using the market approach, we can estimate the CCA or PTA of the company by finding the average multiples of similar SaaS companies based on their customer retention metrics and applying them to the company's metrics. The second example is a subscription-based media company that has a CRR of 80%, a CCR of 20%, a CLV of $5,000, a RPC of $500, a CAC of $100, and a CPP of 2 months. Using the same methods as the first example, we can estimate the DCF, CCA, or PTA of the company based on its customer retention metrics and multiples.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?