What is Customer Lifetime Value?

The easiest way to answer this question is to start with the fact that customers create two different kinds of value for a business:

1. In the short term they buy things, and/or they cost money to serve. This kind of value creation gets reported in the quarterly earnings statement.
2. Over the long term, a customer’s intention to do more business (or not) will generate future sales (or costs), but this value will only be reported in future quarters.

One of the big quandaries for businesses is how to account for this second kind of value, the long-term value that will only be realized tomorrow, even though it is generated by today’s customer intentions.

Generally accepted accounting principles (“GAAP”) account only for currently observed customer transactions, so a company’s financial statements reflect nothing at all about how much value might or might not be created in future quarters by those current customer intentions. This is why the concept of customer lifetime value (LTV) is such an important idea for any customer-centric business, because it helps a business deal with the long-term value created by customers.

The most academically precise definition of LTV is the “net present value of future cash flows attributable to a customer.” Granted, the very definition of LTV involves predicting the future, and no one can really know what the future holds. But businesses wrestle with this kind of uncertainty all the time.

Consider the stock market, for example. A publicly traded stock goes up and down in value on a minute-by-minute basis for all sorts of reasons, including new information, investors looking over their shoulders to see what other investors are doing, and even the way orders are queued for trading. The value of a company’s stock, however, is whatever share of the company’s true economic value it represents for the shareholder. And a company’s true economic value is the net present value of future free cash flow the company is expected to generate (along with the net value of current assets and liabilities). The reason a stock price changes so frequently is because expectations about the volume and timing of future cash flows change constantly, with investor sentiment.

Fischer Black, one of the creators of the famous Black-Scholes model for valuing stock options, once wrote that he would consider a market to be “efficient” if a firm’s stock price were always somewhere between 50% and 200% of its true economic value. In other words, if the true economic value of a company would set its stock price at $100, Black would consider the stock market efficient as long as it valued the company’s shares somewhere above $50 and lower than $200. That’s a pretty wide margin of error, but it’s not a bad guide, given the impossibility of predicting the future.

A margin of error like this might appropriate to apply to customer lifetime values, as well. We often write about lifetime values as if these future cash flows could somehow be calculated precisely, but there are far too many things going on in the future for us to predict any single customer’s actual behavior. LTV analysis can be based on sophisticated statistical models but, as with stock markets, if your estimate of an individual LTV is no more than 50% less or 100% more than actual, perhaps we should count it as accurate enough.

It’s never going to be exact, but in a data-rich environment with large amounts of customer transactional data (such as we find in telecom, retail, SaaS, and financial services businesses), a competent analytics staff can get pretty good at approximating LTV for different types of customers.

And one more thought:

LTV is real. Every customer does have an actual lifetime value.

Just because LTV is based on inherently unknowable future events and is impossible to calculate precisely doesn’t mean it’s not an actual economic quantity. But whether your business acts on this fact or not? That’s up to your business.

In my next post, Part II of this series, I discuss some of the ways we can use LTV as a business building tool - prioritizing our efforts, and even tracking the changes in LTV over time.