Would you spend $10 to procure a $5 sale? Of course you wouldn't, if you measure your business only in terms of individual transactions. But what if you think about the individuals behind the transactions--and what they are worth?

Would you spend $10 once to procure a customer who makes a $5 purchase twice a month for the next two years? Now we're talking.

This is an oversimplification of a marketing metric that goes by several different names:

  • customer lifetime value (CLV or CLTV)
  • lifetime customer value (LCV)
  • life-time value (LTV)

The concept can also be expressed in at least as many different mathematical formulas, with varying levels of complexity. But the basic idea is this: (value of a sale) x (number of repeat transactions) x (projected length of customer retention) = estimated life-time value (LTV)

Or in other words, a $5 sale x 2 times a month x 24 months = $240.

In this scenario, would you spend $10 or maybe even $100 to secure that initial relationship? You'd certainly consider it, as long as you have the cash to float you until it pays off.

LTV is not a new idea in business, and when applied in a realistic and practical way--in concert with other important metrics--it can create clarity, consensus, and long-term growth. But overly fixating on LTV can be just as disastrous as ignoring it altogether. Here are five cautions to keep in mind when applying LTV as a metric to your business.

1. Temper Your Faith in LTV

Numbers are sexy. Sometimes it's tempting to give them more weight than they deserve. Yes, LTV formulas are unassailable when describing past customer behavior, but they are not always predictive of future customer choices, especially if you're breaking into new markets or your own market is getting more crowded.

Remember that every number you're plugging into that formula is an estimate, even when based on past data. The effectiveness of the model is entirely dependent on the accuracy of your assumptions. If just one of the variables is overstated in your forecast, your actual LTV can fall well below expectations. LTV is most valuable as a tactical tool when it's considered alongside the other metrics you use to guide your business; it shouldn't trump or replace them.

2. Don't Equate Revenue with LTV

To state the obvious, you have to take a long-term view to realize the long-term value from your customers. But in the moment, it's still tempting to equate initial revenue with LTV--and to panic at the idea of spending $400 now for $400 in revenue this year. But if you remember you're spending $400 now to gain $4,800 over the next 4 years, that panic quickly diminishes--especially for subscription-based companies, where revenue predictions can be more reliable.

3. Keep CAC in Line with LTV

Some LTV mathematical formulas have the customer acquisition costs (CAC) built in, while others consider it as a separate metric. Just make sure you're keeping CAC in mind. Obviously, the lower the CAC and the higher the LTV, the better your bottom line will look, but there's no magic number that works across every business and industry.

If you'd like to improve your ratio, you can tackle it from either direction. When attempting to lower acquisition costs, make sure you understand how your spend impacts the quality and longevity of the customers you attract. Oftentimes, efforts to decrease CAC can at the same time reduce LTV. You need to be sure the cost reduction doesn't do more damage to the business than good.

You can also improve your CAC to LTV ratio from the other direction, by targeting any of the key customer variables:

  • increasing the value of each sale
  • increasing the number of repeat transactions per customer
  • increasing the length of customer retention

4. Consider Your Cash Status

One danger of putting too much faith in projected customer LTV is that the number can be misused to justify oversized marketing budgets. Increasing your CAC does not always raise LTV, and when it does, it's not always proportional. Available cash flow can act as a natural barrier. Make sure you have enough cash coming in to cover you while you're recouping those early customer acquisition costs--whether that takes 2 months or 2 years.

5. Don't Forget About the Intangibles

Business has never been a game of numbers and spreadsheets only. It's not as simple as saying, "I ran this ad, it cost this much, this many people brought in this much revenue, then this many repurchased, end of story." Your customers bring with them built-in intangible benefits that go beyond strict LTV calculations. As you build a loyal base, customer advocacy increases. Perhaps you paid $300 to win over one original customer, but if she brings three of her friends to your brand, those new customers cost you nothing. And as your customer base grows, both organically and otherwise, so does the intrinsic value of your business if you ever want to sell it. Finally, your market research costs drastically diminish when you have a large, engaged group of customers to observe, survey and gather data from.

6. Just Say No to Low LTV

A final caution; too often, business leaders become overly focused on the money and sales coming in the front door and think: a customer is a customer is a customer. All revenue is good revenue, as long as it helps pay the light bill and the employee salaries.

A more disciplined leader is willing to recognize and walk away from customer segments that have prohibitively low LTVs (i.e., the costs to acquire the customer take too long to recoup, if they ever are). In 2012, Workfront, the company I lead, decided to stop pursuing companies under a certain size. This meant turning down some prospects, choosing not to renew some current customers, and targeting our marketing efforts differently. We haven't looked back. Sometimes, saying no to some customers means saying yes to a more sustainable and strategic direction for the business as a whole.

There's No Magic Formula

Like any other business metric, LTV all by itself is not a magic bullet that will guarantee long-term growth and sustainability. But it can help business leaders look beyond short-term revenue goals, keep customer acquisition costs in check, and realize the benefits (both tangible and intangible) of staying focused on the right customer segments--and avoiding the wrong ones.

Published on: Feb 16, 2016
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.