Calculating CLV

Now let’s walk through a basic CLV model and see how it is derived. We know the conceptual definition of customer lifetime value, as the net present value of future cash flows from any customers. That’s good and great, but how do we actually do that? Let’s walk through this example. Let’s walk through a Netflix customer, right? I got to tell you, it’s squash time again. We are going to go through some numbers here, but I’m going to be with you, I’m going to stick with you through this, we’re going to get through this. So, let’s see, let’s assume the Net Margin per Netflix Customer is $50. M is the gross margin,

R is retention spending.

Retention rate, small r, let’s assume it is 80%. Now, we are going to work this example with June 2014, as the point of context. So the number of customers who joined Netflix in 2014, is 100. So we have some basics here. We know the gross margin, we know retention spending, retention rate, and number of customers who joined Netflix in 2014, 100. And another term I want to introduce here is that, let’s assume these 100 customers are all part of one cohort, the June 2014 cohort. And this cohort word if very important and we will get to it shortly. Now, let’s walk through this. So in June 2014, Netflix has 100 customers.

The total net profit, just, if you were just calculating it for 2014, is going to be. M minus R, which we know from here is 50, times 100 customers.

I’m not that good at arithmetic. You have to tell me what that number is, or Kyle the camera person is going to tell me, if I’m wrong. So I think it is going to be 5,000, Kyle, shake your head if I’m right. Kyle shakes his head, I am right. Okay, so July 2014, what’s going to happen in July 2014? Some of those hundred customers are going to quite the relationship. What does this mean? The retention rate are needs to be multiplied by the number of customers. So in July 2014, there are 80 customers. So what is going to be the total net profit? It’s going to be 80 Times 50.

So that’s going to be 0, 0, and then 5 times 8, is 40. Did I get it right? I see a thumbs up, so I think we are good here. That was a close one. If you go to August 2014, what happens? You have 80 % of 80. That’s r squared here, times 100. So 80% of 80 has to be, how much would 80% of 80 be? That’s going to be about I think, 64 x 50. I think I have this right, I’m not even going to try 64 x 50 on camera and watch, and have you watch me go through that. So let’s just stop there. Okay? You get the point here.

In September 2014, You got 80% times 64, that’s r cubed. So what happens when you do this over time, right? So all you’re doing, and any customer lifetime value calculation is going through this overtime. Right, so let us recap here. V no M is the contribution margin per period for the average customer Capital R is the Retention Spending. Small r is retention rate. And D is discount rate per period. So what is the discount per period mean? This is something we need to understand here. So discount rate is something which we use in finance a lot. So let’s consider a simple example here.

If I give you a dollar today and tell you, I give a loan for a dollar, and then tell you, you can return the loan after a year, I’m not going to be happy if you just come back after a year and give me a dollar. Maybe for you, I’ll be okay. But in general, someone else? I want something more. Let’s say, I want $0.10, but where is this ten cents coming from? The ten cents is something, that I could have made from the market. If I’d taken the dollar, instead of giving the loan to you, give it to the stock market. I would have gotten ten cents on my dollar.

That would make that I would be having $1.10, if I put it in the market. And if you’re returning my money back, I want you to give me about the same money I would have had if I had put the money in the stock market. So the ten cents comes from a discount rate of 10%, right? So whatever we do when we take future cash flow,s and we bring it to present value terms, we have to discount them to bring it to present value terms. So having done all of that, we do some financial math here, and then we get a simple formula out. So the present value of net profit calculation went extended up to infinity.

It’s not like Buzz Lightyear infinity and beyond, maybe it is like that. But if you project the cash flows till, like we say in Texas, the cows come home. CLV is equal to [M- R] times [1 + d] over [1 + d- r]. Is a tough formula right there. Take sometime, look at it register it, think about it, and I will be back to make some intuitive sense, out of this formula.