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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 fraud first of all and

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this is not a huge deal but

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the formula is not applicable to business 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 socalled 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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