**Heads up!** To view this whole video, sign in with your Courses account or enroll in your free 7-day trial.
Sign In
Enroll

Start a free Courses trial

to watch this video

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

When I first learned about the concept of LTV, I was taught a very basic but 0:00 flawed model for calculating it. 0:05 If it's flawed, why am I sharing it? 0:08 Well, because it's a building block for a model that isn't flawed, and 0:10 it's probably something you'll come across at some point. 0:14 In fact, I still see people using it regularly, so just bare with me for a bit. 0:18 A flawed LTV model states that LTV is calculated by multiplying 0:24 the inverse of churn times average revenue per user. 0:28 Or again, LTV = 1 divided by gross customer 0:33 churn times ARPU, why does this matter? 0:37 Well, there's a commonly accepted rule of thumb that the inverse of churn 0:43 will tell us how long our average customers' lifetime is. 0:47 For example, if our monthly churn is 20% 0:51 That means our average customer stays with us for 5 months. 0:56 You can see here you're dividing one by cell B2, which is our monthly churn rate 1:00 of 20% and end up with five months as our average customer lifetime. 1:05 Some of you may be wondering why the inverse of 1:11 churn is equal to a customer's lifetime, it takes a bit of math to compute. 1:14 And if you're interested in calculating that, 1:18 try modelling out this example in your own spreadsheet. 1:21 Imagine you start with 100 customers at the beginning of your exercise. 1:25 Let's expand on our 20% monthly churn, 5 month average customer lifetime example. 1:29 Let's assume we have a subscription service selling access to music for 1:34 $10 a month, and we only have one product. 1:38 In this example our monthly average revenue per user, or ARPU, 1:42 will be $10 per month. 1:47 So, let's add that to our spreadsheet. 1:49 10, and let's just make this dollars so it's nice and clean. 1:54 So we have the inputs we need to calculate our LTV with the flawed formula, 2:00 let's do that now. 2:05 We know that LTV is equal to one divided by gross churn times ARPU. 2:07 So, LTV is equal to our 2:11 customer lifetime time our ARPU. 2:17 So in this example our LTV is 50 dollars, okay, so I know you're getting frustrated. 2:22 Michael why is it flawed? 2:29 Tell us, there are a few reasons why this is fraud first of all and 2:31 this is not a huge deal but 2:36 the formula is not applicable to business which aren't subscription based. 2:38 Maybe we need to think about repeat purchase instead of grocery to arrive at 2:43 customer life time value. 2:48 Think about the grocery store owner, in that situation, 2:50 we need to look at repeat purchase rates, average purchase values, and more. 2:53 We're not gonna get into that in this course, but 2:58 I want you to be aware that we may calculate LTV in different ways, 3:01 depending on the industry or business we are analyzing. 3:04 The more important issue I want us to focus on is that using 3:08 revenue to determine value is misleading. 3:13 Not all products and services cost the same to make, provide or deliver, 3:16 imagen this scenario where we have two different products with the 10% churn and 3:21 a $100 ARPU, translating to an LTV of a $1000 using our flawed LTV model. 3:27 We can see that the model I was first taught for LTV can be misleading. 3:34 I didn't have anyone to point this out to me for 3:38 awhile, I'm grateful that you won't suffer the same fate. 3:41 Let's review that hypothetical example, using the so-called flawed formula 3:44 that LTV of item one is $1,000, but it cost us $500 to make. 3:50 So the net value of that product is $500, 3:55 the LTV of item two is the same at $1000 but 3:59 it costs us $200 to make so its net value is $800. 4:03 In the next video we'll examine this issue further and 4:07 introduce a better way to calculate LTV. 4:11

You need to sign up for Treehouse in order to download course files.

Sign up