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2/3/2017

A Note on Computing Customer Life Time


Value (CLTV)

Lakshman Krishnamurthi
Professor of Marketing
Kellogg School
Northwestern University

Copyright 2017 by Lakshman Krishnamurthi, J.L. Kellogg Graduate School of Management,


Northwestern University, Evanston, IL 60208-2001, tel: (847) 467-1286, e-mail:
LAKSH@kellogg.northwestern.edu. No part of this document may be reproduced in any form or by
any means or incorporated into any information retrieval system, electronic or mechanical, without
the written permission of the copyright owner.
January 15, 2017

Customer Life-time Value Analysis


(CLTV)

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CLTV =
1
1
Where:
N is the number of periods over which the CLTV is
calculated
Mt is the margin (or profit)generated by customer in period t
r is the retention rate for the period, r(t-1) is the survival rate
for period t
i is WACC (weighted average cost of capital) for the period
AC is the acquisition cost
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The CLTV formula


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1
1

2 1
1 2 3
= + 2 + 3 + . + - AC
1 1 1 1

0 1 2 3 4 5 6 7 8

This formula assumes that you keep the customer in period 1, have
r% probability of keeping the customer in period 2, r2 in period
3, and so on 3

The CLTV formula


We will assume an infinite horizon
Also, for simplicity, we will assume M is constant over time.

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Infinite 1
1

1 2 9
+ 2 + 3 + . + 10 ] - AC
1 1 1 1

1
= M [1 + x + x2 + x3 + ..] - AC
1

Here x = r/(1+i). Sum of the infinite series 1 + x + x2+ x3 + .where


x < 1 equals: 1/(1-x).
1/(1-x) where x=r/(1+i) equals 1/[1-r/(1+i)] = 1/[(1-r+i)/(1+i)] =
(1+i)/(1-r+i). Thus, M*[1/(1+i)] (1+i)/(1-r+i) = M[1/(1-r+i)]
CLTV =

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The CLTV formula


Note that the terms in should be consistent. That is, if the
period is a month, then M is the monthly margin, r is the
retention rate for the month, and i is the monthly WACC
Similarly, if the period is a year, M is the annual margin, r
is the annual retention rate, and i is the annual WACC
Remember, whether we compute the first part of the CLTV
formula [M/(1-r+i)] using annual terms or monthly terms, it
does not mean the CLTV is for a year or a month. It represents
life time value. How is that?
The CLTV formula is the net present value of a stream of
earnings from a customer, adjusted for the probability that the
customer is alive, subtracting the acquisition cost. The formula,
assumes an infinite horizon, not a month or a quarter or a year,
but for ever!
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The CLTV formula


If you know the average monthly churn c, say, c=2%,
but want to use the formula using annual data:
Retention (r) = 1- churn
Monthly retention = 1-0.02 = 0.98
Annual retention = (0.98)12 = 0.785
Incorrect to compute annual churn as 12*0.02 = 0.24, and annual
retention = 1-0.24 =0.76
Why is that?
Say you start with 100 customers, and your churn rate is 2% per
month. At the end of the first month you are left with 0.98*100 = 98
customers
At the end of the 2nd month, you have 0.98*98 = 96.04 customers,
and so on
At the end of 12 months, you are left with 78.5 customers, not 76
customers 6

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The CLTV formula


Note that CLTV will be different depending on the time
period used as explained later in this note
If the churn rate is given monthly or quarterly instead of
annually, why not use the CLTV formula where all the
data are in monthly or quarterly terms?
You certainly could, but the WACC or discount rate is
typically an annual rate. So, you have to convert this to a
monthly or quarterly rate
So, for example, if the WACC is 10% on an annualized
basis, the implied monthly rate is (1.10)1/12 =1.0079, so i
would be 0.0079 (0.79%), and the implied quarterly rate is
(1.10)1/4 = 1.0241, so i = 0.0241(2.41%)
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The CLTV formula


Note that the lifetime profit part (the first term) of the
infinite CLTV formula is the same as the value to
perpetuity when r=1
If you ignore discounting, the CLTV simplifies to:

CLTV =
Since retention r = 1-churn, churn = 1-r. So, 1-r in the
denominator of the formula is simply the churn for the
period, and [1/(1-r)] is the number of periods the average
customer will be alive
For example, if monthly churn is 4%, the average customer
will be alive for 1/(0.04) = 25 months
Then, the lifetime profit of the average customer is M*25, and
CLTV = M*25 - AC
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The CLTV formula


Let us consider the CLTV formula without discounting,
so CLTV = [M/(1-r)] AC.
Suppose you are given the monthly churn as 3%. Say, M = $50/month.
The monthly retention rate = 1-0.03 = 0.97
The equivalent quarterly churn = 1- 0.973 = 0.087 (8.7% not 3*3% = 9%)
The equivalent half-yearly churn = 1- 0.976 = 0.167 (16.7%, not 6*3% = 18%)
The equivalent yearly churn = 1 0.9712 = 0.306 (30.6%, not 12*3% = 36%)
CLTV
Monthly = [$50/0.03] AC = $1667 - AC
Quarterly = [3*$50/0.087] AC = $1724 - AC
Half-yearly = [6*$50/0.167] AC = $1796 - AC
Annually =[12*$50/0.306] AC = $1961 AC
This is a consequence of the non-linear formula. If quarterly churn is
computed as 3*monthly churn, semi-annually as 6*monthly churn, and annual
churn as 12*monthly churn, all four answers would be the same. But, that is
not the correct way to compute the value.
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The CLTV formula


As long as you are consistent in the time period you use, the
comparison of CLTV for two different segments will not be affected
What should M represent? In the case of product sales, it should be
gross margin (or contribution margin which means only variable costs
are subtracted) minus direct marketing costs of generating the sale and
retaining the customer. In the case of service sales, it should be
revenue minus direct costs of generating and retaining the revenue.
Non-direct Sales & Marketing costs such as advertising, G&A, R&D,
etc., are typically excluded. So, the fact that CLTV is positive does not
mean the company is profitable
It is best to compute CLTV by different segment of customers, because
they could have different churn rates, and different cost of generating
revenue
Sometimes a revenue number is used for M instead of margin. This
happens when a company is quite new and does not have a good
handle on direct costs of generating the revenue
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The CLTV formula


CLTV computed using a particular value of M and r
represents the average value of a customer belonging
to that segment. Customers get acquired and others
leave. Some may quit in a few days, some may last
years. The company makes very little money (or
loses money) on those who leave very soon and a lot
more money on those who stay long. But, the CLTV
is the same for any of these customers, because it
represents the average value.

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An alternate CLTV formula


If we assume we start with the customer at the beginning of
period 1 and assume there is a r% probability of retaining the
customer at the end of period 1, r2% probability of retaining the
customer at the end of period 2, r3% probability at the end of
period 3, and so on, then the CLTV formula will be:


1
1

2 3 10
+ 2 + 3 + . + 10 ] - AC
1 1 1 1

= M [1 + x + x2 + x3 + ..] - AC
1

This simplifies to
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Use of the infinite formula


The infinite formula is an approximation, but a very good one and is simple
to compute as compared to the period by period formula
Let M = annual margin and AC be the upfront acquisition cost, and let i =
10%
We will assume the prob the customer is alive in year 1 is 100%
If the annual retention rate is low, say 40%, the probability the customer is
alive is 40% in year 2, 16% in year 3, and 6.4% in year 4
Using the period by period computation up to period 4 will yield Customer
Value of 1.404M AC. Using the infinite period formula yields a value of
1.43-AC
Suppose, annual retention rate is a high 80%. Then, there is a 13%
probability that the customer is alive in year 10. Computing customer value
period by period for 10 periods yields 3.2M AC. Using the simpler infinite
period formula yields 3.33M AC
If the period by period computation is only carried out for a few periods, the
infinite approximation is better when the retention rate is low
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When to use the period by period


formula

The margin M (either monthly or annual) is assumed


constant to simplify the derivation of the infinite
period formula. The margin will vary but an average
M will work fine if the variations are small
It is better to use the period-by-period formula if Mt
changes substantially from period to period. If M
increases over time, a period-by-period computation
is better, but the present value of the money is not
worth much if the discount rate is high

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