What is a Customer Actually Worth?

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You know what's scary to hear when you're discussing advertising costs?

"It's okay, we'll make it up on the LTV."

And yet, I've heard it dozens of times, from fellow retailers in a wide array of verticals.  On the surface, it makes sense, though, doesn't it?  You can afford to spend a bit more up front, if you take into account the fact that your customers will come back and place subsequent orders, right?

Possibly.  But you'd better have data to back that up, and only a handful do.  For every replenishment-driven site with their retention dialed perfectly, there are fist-fulls of other retailers that don't know where to start to answer questions like "how much is an email sign up worth to us?"

There are a ton of ways to approach the task of determining Lifetime Value (LTV), but hopefully sharing my favorite puts you on a path toward creating yours.

You don't have ONE conversion rate.  You have several.

First, you need to toss out the idea of a universal "Conversion Rate".  You actually have a 1st Conversion Rate, a 2nd Conversion Rate, a...

  1. How many visitors become first-time customers?
  2. How many first-time customers place a second order within a year?
  3. How many two-time customers place a third order within another year?
  4. How many three-time... etc.

I use a year as my window, simply because I come from a seasonal retail background--your business may have a different cadence.  The likelihood of additional conversion do tend to increase as you go, assuming you provide a desirable customer experience.  That part is true!  But that likelihood starts to roll off at some point.

Let's say this is that roll-off, for the sake of demonstration:

 

 

These are based loosely on data I've seen from a number of commodity, non-replenishment retailers, so they're sufficient for our purposes.  You can pull the 1st Conversion Rate from Google Analytics.  The latter Rates, you could pull from looking for counts of distinct email addresses over time from your order history.  How many of your customers have two or more orders, relative to the total population?  How many have three or more, relative to two?And so on.

Now, you have the tools to actually estimate the Lifetime Value of a new customer!

Next, I'll show you how to use these values to actually determine a dollar value for your customers!

Calculate Forecasted Revenue Shares

Let's assume an Average Order Value (AOV) of $100.  Consider a customer who's only placed one order so far.  All things being equal, in our example, the 2nd Conversion Rate is 22%--there's a 22% chance they'll place a second order.

You've already collected $100 from them, on that first order, so you know you have that money.  Let's start there--LTV so far is $100!

With a 22% chance of a repeat order, since you're actually using this customer as a metaphor for a very large group of customers, you can treat that as being worth $22 (that's the chances of it happening, times the AOV).

You now have an LTV of $122!

How about that third order?  Well, you have to place two orders before you can place a third, so the odds of our one-time customer placing a third order is 8.58% (that's 22% for the 2nd times 39% for the third).  You've just added another $8.58 to the LTV.

You now have an LTV of $130.58!

You have to place a third order before a fourth, and a second before that, so the odds that our one-time customers will place a fourth order is 3.95% (.22*.39*.46).  That's another $3.95.

LTV is now $134.53!

And so on!  The incremental additions get smaller and smaller, and your iterations end up rolling off, like so:

 

 

It doesn't take that many iterations to get to the point where the additions are less than a dollar--and not many more before they're less than a penny.  In this example, it's safe to say that the LTV is about $135.

If you know your margins, you could then convert this revenue-based LTV into a margin-dollars version, or even a profit-dollars version.

I'm biased--I like making money on every sale, but I know that's not the only way to do business.  I knew one cosmetics retailer that knew exactly how much they could lose on the first sale, because their retention rates were so carefully measured and nurtured, and they used that as a weapon.  If our example company were to follow in those footsteps, they could theoretically set their Cost Per Acquisition (CPA) targets based on the $135 number, rather than the $100 one.

This can then empower you to answer another very common question!

How much is an email address worth to us?

Let's assume that the address is well-qualified, and is entirely expected to behave like other addresses you've collected before.  Buying lists, for example, throws this entire approach out the window.

To go from our LTV value of $135 to our new email address value, all we have to do is go back and plug in a relevant 1st Conversion Rate.  Multiplication is commutative, so it's fine that we're doing it at the end.  This Conversion Rate ought to be a measurement of how many new email addresses turn into first time customers within your timeframe (mine's a year, recall).

If that's 10%, then you know that you have to collect ten email addresses to produce one customer (on average, once again).  That means that each address would be worth $13.50 in LTV revenue, all else being equal.

If our hypothetical margins are 35%, then that's $4.73 in gross margin per email, so if my cost to collect those addresses is $5 or more, I'm setting myself up to lose money!

I hate losing money.  This approach to LTV helps me avoid it.  I hope it does the same for you!

Up and to the Right!