Lifetime Value & Customer Acquisition Cost: A Framework For Investing

Last Wednesday we dove deep into unit economic analysis. We discussed what it is, why it’s important and how to use it in investment analysis.

Alta Fox Capital founder, Connor Haley, stressed the importance of unit economics during our podcast. You can find that here.

This week we’re diving deep into a similar concept, lifetime value (LTV) and customer acquisition cost (CAC). These concepts are similar to unit economics in that it breaks down a business model to its basic components:

Many investors think “software business” when they hear LTV and CAC. But these concepts translate across sectors and industries. Whether it’s a chemical plant or back-end accounting software company. The fundamentals don’t change.

What is the Lifetime Value of A Customer?

LTV is the total revenue a customer will generate for your business while they remain your customer. Given that definition there’s a couple ways we can think about this.

First, companies want to keep customers as long as possible to maximize LTV. The longer customers engage with you, the more money you’ll generate from that customer. This is because it costs more money to acquire new customers as it does to please existing ones.

The shorter the lifetime, the more costly it becomes to conduct business. You spend more time (and money) trying to find new customers. This leaves fewer resources for reinvesting or improving the existing customer experience.

How To Calculate Lifetime Value (LTV)

Let’s put some math behind the concept. Here’s how we calculate LTV (from profitwell.com):

In short, it’s the Average Revenue Per User (customer) divided by the churn ratio (how often your customers leave).

ARPU is self-explanatory. Churn ratio is more complex, a derivative of retention rate. There’s two ways we can define retention rate: customers and revenues. Let’s focus on the customer.

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Disclaimer: All statements are solely opinions and are for educational purposes only.

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