Why Does LTV Matter?4:19 with Michael Watson
We discuss some reasons why LTV is a useful metric.
Now we know what LTV is, but why does it matter? 0:00 Well, all else equal, businesses do better with LTVs that are growing. 0:04 That's because growing LTVs are indicators that customers are sticking around longer, 0:10 purchasing more from our business, and or buying higher price products from us. 0:15 So, generally speaking, 0:21 people inside businesses want to figure out how to grow the LTV of their products. 0:23 There are so many potential uses for LTV data, but the most common application I 0:29 come across is in the context of comparing it to customer acquisition costs. 0:34 Let's walk through an example together. 0:39 Here we have data on a hypothetical business. 0:42 We see the gross profit LTV of the business and 0:45 also the customer acquisition cost or CAC. 0:48 Sometimes we'll see CAC referred to as CPR or CPA, 0:52 which are shorthand for cost per registration or cost per acquisition. 0:57 This is another acronym that can vary by business so we should confirm it with our 1:03 colleagues or team, but just think of CAC as the cost to acquire a customer. 1:08 Similar to COGS, defining CAC can command its own course. 1:13 But in our simple example, 1:18 let's assume that this $30 CAC represents some advertising spend, 1:20 as well as an allocation for the sales and marketing teams' salaries and benefits. 1:25 In SaaS or Software as a Service businesses, 1:31 there is a rule of thumb that we want our LTV to CAC ratio to be 3 or larger, 1:34 5+ would be exceptional, 3 is good and 1 means we are breaking even. 1:40 Numbers less than 1 mean that we are spending a lot more to acquire a customer 1:47 than the value they provide our company. 1:52 If our LTV to CAC ratio dips below 1 we should definitely spend time 1:54 scrutinizing this or closely monitoring it. 1:59 We probably want to stop the acquisition activity altogether, 2:03 because we're expecting to lose money on it from the start. 2:06 LTV to CAC is just a ratio that captures our LTV 2:10 after COGS have been factored in, and our customer acquisition cost. 2:14 So the ratio doesn't account for 2:18 any overhead costs that we are going to have to pay for. 2:21 This would include costs for the finance team or engineering. 2:24 What about rent? 2:28 So in this example let's see what happens if our customer acquisition costs 2:29 increase significantly. 2:35 Let's say they go to 60. 2:36 Well we're now below that magic number of 3 for the LTV to CAC ratio so 2:39 we need to dig in and if this goes to 150, boy we're in big trouble. 2:43 We need to sound the fire alarm. 2:50 In a lot of organizations, finance and 2:52 marketing will monitor these metrics closely to inform decision making today. 2:55 A marketer might ask, what's the most we can spend on acquiring a customer? 3:00 Finance would reply with guidance based on the latest LTV information available, and 3:05 the company's strategic goals. 3:10 If LTV is increasing, all else equal, 3:12 marketing could be given room to spend more on customer acquisition. 3:16 Companies that are emphasizing growth over profitability 3:20 have been known to spend at the LTV to CAC ratio level of 1. 3:24 Note that this is not a sustainable long run strategy 3:29 without the ability to finance overheads from other businesses or capital sources. 3:33 If we have a broad business goal to increase LTV, then teams 3:40 will unpack the components of it, and try to positively impact the numbers. 3:44 There's a lot of ways to do that. 3:48 We know that ARPU, COGS, churn, they all impact LTV. 3:51 A product team might look at two different groups or cohorts of customers and 3:56 make some changes to the user experience to see if it reduces churn. 4:01 We may conduct an experiment where we charge a different price and 4:05 see how the changes to ARPU impact LTV. 4:10 We can see that there are many different possibilities to positively or 4:12 negatively impact LTV. 4:17
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