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We introduce a basic, but ultimately flawed formula for calculating LTV.

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When I first learned about the concept
of LTV, I was taught a very basic but
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flawed model for calculating it.
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If it's flawed, why am I sharing it?
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Well, because it's a building block for
a model that isn't flawed, and
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it's probably something you'll
come across at some point.
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In fact, I still see people using it
regularly, so just bare with me for a bit.
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A flawed LTV model states that
LTV is calculated by multiplying
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the inverse of churn times
average revenue per user.
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Or again,
LTV = 1 divided by gross customer
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churn times ARPU, why does this matter?
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Well, there's a commonly accepted rule
of thumb that the inverse of churn
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will tell us how long our
average customers' lifetime is.
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For example, if our monthly churn is 20%
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That means our average customer
stays with us for 5 months.
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You can see here you're dividing one by
cell B2, which is our monthly churn rate
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of 20% and end up with five months
as our average customer lifetime.
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Some of you may be wondering
why the inverse of
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churn is equal to a customer's lifetime,
it takes a bit of math to compute.
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And if you're interested
in calculating that,
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try modelling out this example
in your own spreadsheet.
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Imagine you start with 100 customers
at the beginning of your exercise.
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Let's expand on our 20% monthly churn,
5 month average customer lifetime example.
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Let's assume we have a subscription
service selling access to music for
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$10 a month, and we only have one product.
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In this example our monthly
average revenue per user, or ARPU,
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will be $10 per month.
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So, let's add that to our spreadsheet.
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10, and let's just make this dollars so
it's nice and clean.
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So we have the inputs we need to calculate
our LTV with the flawed formula,
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let's do that now.
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We know that LTV is equal to one
divided by gross churn times ARPU.
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So, LTV is equal to our
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customer lifetime time our ARPU.
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So in this example our LTV is 50 dollars,
okay, so I know you're getting frustrated.
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Michael why is it flawed?
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Tell us. There are a few reasons
why this is flawed. First of all, and
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this isn't a huge deal, but
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the formula is not applicable to businesses
which aren't subscription based.
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Maybe we need to think about repeat
purchase instead of grocery to arrive at
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customer life time value.
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Think about the grocery store owner,
in that situation,
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we need to look at repeat purchase rates,
average purchase values, and more.
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We're not gonna get into
that in this course, but
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I want you to be aware that we may
calculate LTV in different ways,
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depending on the industry or
business we are analyzing.
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The more important issue I want
us to focus on is that using
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revenue to determine value is misleading.
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Not all products and services cost
the same to make, provide or deliver,
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imagen this scenario where we have two
different products with the 10% churn and
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a $100 ARPU, translating to an LTV of
a $1000 using our flawed LTV model.
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We can see that the model I was first
taught for LTV can be misleading.
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I didn't have anyone to
point this out to me for
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awhile, I'm grateful that you
won't suffer the same fate.
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Let's review that hypothetical example,
using the so-called flawed formula
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that LTV of item one is $1,000,
but it cost us $500 to make.
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So the net value of that product is $500,
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the LTV of item two is
the same at $1000 but
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it costs us $200 to make so
its net value is $800.
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In the next video we'll
examine this issue further and
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introduce a better way to calculate LTV.
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