Lifetime Value (LTV)

Lifetime Value (LTV) (also known as Customer Lifetime Value or CLV) is a crucial metric that estimates the total net profit a company can expect to earn from an average customer over the entire duration of their relationship. Think of it as the total worth of a customer to the business, not just from a single purchase, but from all their future purchases combined. For a value investing practitioner, LTV is a powerful lens through which to assess the underlying quality and durability of a business. A company with a high LTV often possesses a strong competitive advantage, or moat, because it indicates happy, loyal customers who repeatedly choose its products or services over competitors. This “stickiness” can stem from superior products, excellent customer service, or high switching costs, and it often translates into predictable, recurring revenue and strong pricing power—the hallmarks of a wonderful business that can compound its value over time.

Beyond a simple accounting number, LTV tells a story about a company's relationship with its customers. A high or rising LTV is a sign of a healthy, sustainable business model.

• Focus on Long-Term Quality: LTV shifts the focus from short-term sales figures to long-term value creation. A company that excels at maximizing LTV is building a fortress of loyal customers, not just a temporary sales booth.
• Indicator of a Moat: As mentioned, high LTV is often a direct result of a strong moat. Customers don't stick around for years by accident. They stay because the company offers something uniquely valuable that competitors can't easily replicate.
• Profitability of Growth: LTV helps an investor determine if a company's growth is profitable. It’s easy to grow revenue by spending lavishly on marketing, but if the new customers leave after one purchase and their LTV is low, that growth is an illusion built on a leaky bucket.

While the precise formulas can get complex, understanding the components is what truly matters for an investor.

At its most basic, you can think of LTV with a simple, intuitive formula: (Average Value of a Sale) x (Number of Repeat Transactions) x (Average Retention Time) This gives you a rough idea of the total revenue one customer might generate. However, to get a more accurate picture, we need to consider profitability and the time value of money.

A more sophisticated LTV calculation incorporates several key concepts:

1. Average Purchase Value: The average amount a customer spends in a single transaction.
2. Purchase Frequency: How often a customer makes a purchase in a given period (e.g., 4 times a year).
3. Customer Lifespan: The average length of time a person remains a customer. This is often calculated from its inverse, the customer churn rate (the percentage of customers who stop doing business with the company in a period). A 10% annual churn rate implies a 10-year average customer lifespan.
4. Gross Margin: This is critical. We want the profit from a customer, not just revenue. Multiplying by the gross margin percentage converts revenue into profit.
5. Discount Rate: Money tomorrow is worth less than money today. To properly value future profits, they must be converted to their present value using a discount rate. This accounts for the time value of money and investment risk.

The key takeaway is that LTV is not just revenue; it's the discounted gross profit expected from a customer over their lifetime.

Imagine two coffee shops, “Quick Caff” and “Cozy Corner.”

• Quick Caff: Sells cheap, generic coffee. It relies on a high-traffic location. Customers grab their coffee and leave, rarely returning with any loyalty. Their average customer might only visit a few times. The LTV here is very low.
• Cozy Corner: Sells premium coffee but also fosters a community with friendly baristas, a loyalty program, and a pleasant atmosphere. Customers become regulars, visiting multiple times a week for years. Cozy Corner has a much higher LTV per customer.

A value investor wouldn't just look at one week's sales. They would recognize that Cozy Corner has a far superior business model. Its high LTV suggests a durable brand and predictable future cash flows, making it a more attractive long-term investment.

LTV becomes even more powerful when compared to another key metric: Customer Acquisition Cost (CAC). CAC is the total cost of sales and marketing spent to acquire a single new customer. The LTV/CAC ratio is the magic number. It tells you the return on investment for acquiring new customers.

• LTV/CAC < 1: Disaster. For every dollar spent acquiring a customer, the company gets less than a dollar back in lifetime profit. The business is losing money with every new customer.
• LTV/CAC = 1: The company breaks even on its customers. This is not a sustainable model.
• LTV/CAC > 3: Generally considered a good, healthy ratio. For every dollar spent, the company gets three or more dollars back in profit over the customer's lifetime.
• LTV/CAC > 5: Excellent. This indicates a very strong business model with efficient marketing and a sticky product.

As an investor, you want to find companies with a high and ideally improving LTV/CAC ratio. This signals a highly profitable and scalable business.

While powerful, LTV is not infallible. Keep these points in mind:

1. It's a Forecast: LTV is an estimate based on historical data and assumptions about the future. These assumptions can be wrong.
2. Check the Assumptions: When a company discloses its LTV, be skeptical. Dig into how they calculate it. Are they using revenue or profit? What churn and discount rates are they assuming?
3. Context is King: LTV is most useful for businesses with recurring revenue models, like subscriptions (e.g., Netflix), software-as-a-service (e.g., Adobe), or frequent repeat purchases (e.g., Starbucks). It's less relevant for a company that sells jumbo jets.
4. Look for Trends: A single LTV number is less useful than its trend over time. Is the company's LTV per customer increasing or decreasing? This reveals whether the business's competitive position is strengthening or weakening.