CLV Accuracy: Are You Overestimating or Underestimating This Key Metric?

Customer Lifetime Value, or CLV, is a key metric that represents how much cash the average customer spends during their relationship with a company – or in other words, how much they’re worth to a business.

So why is Customer Lifetime Value so important?

It’s important because few customers are worth the price of their first purchase. Depending on your business model, your customers might make repeat purchases or sign up to a recurring contract. Focusing only on that initial metric (the first purchase) is incredibly short-sighted, and likely to drastically slow growth.

Understanding your CLV also helps with forecasting. You can predict (with varying degrees of accuracy) your future cash flow. CLV is very different than customer loyalty (and more important). That’s because it’s a tangible metric that can help you make smarter business decisions.

But there’s more to leveraging CLV than simply punching in some numbers and calculating what your customers are worth to you. Here’s what you need to know.

CLV and CAC

CLV is a critical business metric that all companies can and should be measuring. In isolation, however, CLV doesn’t tell the full story.

To understand the lifetime value of a customer, you need to know your CAC too.

CAC stands for Customer Acquisition Cost – the cost of bringing a new customer on board. Every company should be calculating their CAC, because a customer can only generate profit once their spend exceeds their acquisition cost. If your CAC exceeds your CLV, your business is unsustainable.

Calculating CAC

The simplest way to calculate CAC is to take your total acquisition cost for a set period (i.e. marketing and advertising spend, including staff wages, agency fees, and campaign costs) and divide it by the number of customers acquired during that time frame.

You can read more about calculating CAC here.

Take your CAC away from your CLV, and you’ll instantly have a better understanding of each customer’s worth. Without this, you’ll almost certainly be overestimating your CLV.

Calculating CLV

That being said, it’s nearly impossible to accurately calculate CLV. You can use historical trends to predict future behavior, but customers are human, and possess the unique needs, traits, and unpredictability that come with that. There are too many variables to ever say for certain what each customer will be worth.

That’s not to discount the importance of CLV. It may not be a perfect or foolproof metric, but it’s invaluable when used correctly. It helps with business planning and budgeting, and makes it easier to keep your expenses in check.

So how do you calculate CLV?

This depends in part on your business model, and in part on what’s right for you and your business. In other words, there’s no one or “correct” way to calculate CLV.

Smile.io suggests retail companies multiply their average order value by their average purchase frequency to calculate CLV. You can also factor in your margin to calculate how much profit a customer generates over their lifetime, instead of how much revenue they’re bringing in.

But what about SaaS companies? How can they calculate their CLV?

First, you’ll need to know your churn rate (the percentage of subscribers who cancel within a set period). If you’re just starting out, you’ll have to guesstimate your churn rate, and make assumptions about your CLV. The longer you’re in business, the larger the pool of data you’ll have to pull from, and the more accurately you can calculate your churn rate and your CLV.

Using Netflix as an example, Smile estimates that the streaming giant’s current annual churn rate is 5%. From there, they work out that the average customer uses Netflix for 20 months. Multiply this by the average spend ($11.32 a month) and Netflix’s CLV is $226.40.

Of course, they need to account for acquisition costs. We know that new customers get their first month for free, so that 20 months becomes 19, for a CLV of $215.08. This is ignoring the fact that we know Netflix does more marketing and advertising than simply offering a free trial, but the specifics don’t really matter. Multiply your average monthly spend by the number of months the average customer sticks around, take away your CAC, and you have your CLV – or at least a very simplified version.

The above calculations are averages across all your customers. Be aware that generalizing to this extent could result in your grossly overestimating or underestimating your CLV.

You may want to estimate churn rate and CLV for different demographics, or in line with past behaviors or price tiers.

You may also want to factor in how customer spend can change over time. Is average spend likely to increase or decrease over time? Even small changes in revenue can make a big difference to your CLV when we’re talking about a large number of customers.

The Problem with Overestimating or Underestimating CLV

We know that it’s nearly impossible to measure CLV with 100% accuracy, but unfortunately, both overestimating and underestimating CLV present problems.

Overestimating CLV can inflate revenue projections and result in overspending. Underestimating CLV can cause companies to be too cautious with their outlays, hindering growth and limiting profit.

So what’s the right balance?

Again, even a small over or underestimation can cause big problems at scale. However, while it’s ill-advised to over or underestimate, it’s always better to err on the side of caution. To be safe instead of sorry, make sure you’re underestimating, not overestimating, your CLV.

The reason why is pretty simple.

Overspending (as a result of overestimating CLV) presents a far greater risk to the future of your organization than underspending.

Sure, most of us know we need to spend money to make money, but underinvesting rarely presents as significant or immediate a risk as overinvesting.

To be as certain as possible that you’re not overestimating, try making multiple calculations based on different scenarios, and use the lowest outcome as your CLV. This will then be the basis from which you determine your spend on customer acquisition.

How does your organization estimate this key metric? Comments are below if you have a moment to share how you calculate your CLV:

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