A general framework for customer lifetime value

Daniel McCarthy

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 Public adoption of CLV is growing

Important metrics:
• Acquisition Cost
• Retention
• Average Revenue Per User Slack’s pre-IPO filing
• Contribution Margin http://bit.ly/2JSAniN
• …

Peloton’s pre-IPO filing

http://bit.ly/2m5b4R7 2
 But how is CLV defined, actually?

What CLV is to most people in What CLV is to most people in

industry: finance/accounting:

A concept or way of life Partially a concept, partially a score

What we are slowly working towards: CLV as a valid, consistently and
precisely defined value that can actually be used to assess path to
profitability

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The taxonomy of CLV

For this reason, we will not only define CLV, but also provide many
variants that, while useful in their own right, are not CLV (but are
often confused with CLV).

Main distinctions: CLV versus…

1. Post-acquisition value (PAV)
2. Residual lifetime value (RLV)
3. Historical value (HV)
4. Sales CLV (S-CLV)
5. Finite-horizon CLV
6. Undiscounted CLV
7. Repeat PAV

When people use CLV incorrectly, correct them! You will be helping 4

us all legitimize and standardize a metric that is still very “loosey

Customer Value: General approach
 Assume we had a crystal ball which told us what a particular customer
will do and when that customer will churn:

55 150 290 310  𝑡

Past Future
CAC

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 CLV and “post-acquisition value” (PAV)

 CLV is the net present value of *all* variable profits/costs (including CAC )
 PAV is CLV before we deduct CAC   1
¿
( 1+.00031 )310

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CLV and “post-acquisition value” (PAV):
comments
 CLV and PAV are very often confused with one another…
 It can be very informative to separately track PAV and CAC across
cohorts – different trends sometimes.
Blue Apron Recent diligence

 PAV determines upper bound on how much to spend on CAC

 CLV determines whether you’re “upside down” or not
 Very dangerous: a business with high CLV and a CAC of $0
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 Residual lifetime value (RLV)

 RLV is the NPV of all *future* variable profits, relative to today

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RLV: comments

 Acquisition is all about CLV, retention is all about RLV

– The goal of retention strategies is to increase what remaining value can be extracted
(net of the cost of the retention strategy) – the past can’t be changed
 Some people confuse CLV and RLV (but this is less frequent)

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 Historical value

 HV is the NPV of all *past* variable profits, relative to today

>1 because we’re
“bringing them forward”
in time

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 HV: comments

  Believe it or not, many people who say CLV actually mean HV

 Relating CLV to HV and RLV:
– Mathematically,
 Not generally useful on its own, except as a “plug” to get to CLV

https://www.bounteous.com/insights/2016/
02/18/tracking-customer-lifetime-value-go
ogle-analytics 11
 Sales CLV and Sales PAV

 S-CLV is the net present value of all sales, minus CAC

 S-PAV is S-CLV before we deduct CAC

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 S-CLV and S-PAV: comments

 S-PAV is diagnostic in its own right, although as with the other variants, is
very frequently confused with (profit-based) PAV
 S-PAV versus PAV from a recent diligence:

 S-CLV is a useless measure. Comparing sales to CAC is silly unless variable

margin is 100% (then S-CLV = CLV)
 Remember: sales on its own does not create value. Cash flow creates value

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 Finite-horizon CLV

 Finite-horizon CLV is the net present value of all future variable

profits/costs over a particular finite horizon
 3-month CLV:

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 Finite-horizon CLV:
comments

 Often used because shorter horizons are observable

– In theory, CLV is never observed!
–  more amenable to SEC disclosure
 Shorter horizons are also easier to predict, which is appealing
 Often, the rank of customers for a reasonably long finite-horizon
CLV will be the same as (an infinite-horizon) CLV, so for a fixed
customer acquisition budget, the outcome would be the same
 Appeal of finite-horizon CLV is somewhat analogous to appeal of the
“payback period”
 Most common finite horizons: 6-month, 1-year, 3-year, 5-year

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 Undiscounted CLV

 Undiscounted CLV is the sum of all variable profits/costs associated with a

customer (i.e., no discounting, or the NPV assuming a 0% discount rate)
 Undiscounted CLV:

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Undiscounted CLV: comments

 Very frequently confused with CLV, especially in mobile gaming

 Overestimates value of customers because it does not account for the
time value of money
 When lifetimes are generally very short, the error associated with
using an undiscounted CLV goes down, but even then… why not just
do it the right way?
– To be fair: one reason is for SEC disclosure, what discount rate
should be used? No universally agreed upon discount rate

h/t Zach Winston

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 Undiscounted CLV: an example

Peloton (S-1):

No discount rate

Incorporate a reasonable discount

rate and these values fall by 50%+!

https://hbr.org/2020/01/the-loyalty-economy#how-to- 18
value-a-company-by-analyzing-its-customers
 Repeat PAV

 Repeat PAV is CLV ignoring CAC and first purchase profitability

(often referred to as “net CAC”)
 Repeat PAV:  Net CAC:

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Repeat PAV and Net CAC: comments

 In English, value from “first purchase” versus “everything else”

 Intuitive, considering companies typically generate sales (and variable
profits) on the first purchase that “births” the customer
 Philosophically aligned with notion of payback period (and first
purchase profitability – more soon on that)
 Peloton disclosed Net CAC in their S-1!

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 A general CLV formulation

  customers.
is equivalent to getting average CLV for the next, say, 1,000 acquired
Formula:
 

 Under (typically not too damning) assumptions,

Definitions for the other CLV variants follow accordingly.

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Lessons
 CLV is being discussed and used more than ever…
 … but for most people, CLV is still loose cheap talk
 Many important distinctions to draw  taxonomy of CLV
 Many CLV variants are useful in their own right
 My recommendation: compute all meaningful measures by
cohort and segment. Depending on goal, use accordingly.

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Addendum 1: another CLV distinction

 Cash flow versus accrual-based CLV

– You will often encounter CLV definitions involving cash flows instead of
variable profits (i.e., an income statement figure)
– In theory, cash flow CLV makes all the sense in the world but practically
speaking, not so much
– Marketing does not drive cash flow conversion. Receivables, purchasing,
finance, etc. do.
– Importantly, allocating cash flow costs is much harder than cash flow sales

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Addendum 2:
How CLV varies by business model
 Let’s consider the ingredients of CLV and how they differ by business
model: Subscription Non-subscription

1. CAC
Churn is Churn is
2. Retention observed unobserved
Discrete Continuous (often variable
3. Order while alive (typically one per across customers, over
month)
Less variable Moretime)
variable
4. Spend given order

5. Profit given spend

Underlying ingredients are the same, but different

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models are necessary to account for differences
Addendum 3: Roadmap for our modeling
 Specify models for each of these processes:
– Retention
– Order rate while alive
– Spend per order
– Variable margin %
 Train models upon all available data
 Predict what each customer will do, given past
 Bring predictions together to estimate CLV/variants
 Analyze results and update strategy accordingly

This is basically what we’ll spend the rest of the semester on

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