Unit Economics - What's Wrong with the CLV Magic Metric

The CLV/CAC metric is a misleading metric.

In short, the conclusion that the CLV / CAC metric is misleading is a direct consequence, including, of my previous article, which can be viewed at the link:

Unit Economics – the main thing about the CLV (Customer Lifetime Value) metric

Let me remind you that the key conclusion of this publication is that the CLV metric is based on the NPV metric known from finance and investment analysis, i.e. in simple terms we can define CLV as

CLV = NPVc = PVc – CAC , where

CLV – Customer Lifetime Value (customer lifetime value)

NPVc – Net Present Value of Customer Cash Flows

PVc – Net Present Value of Customer Operating Cash Flows

САС – initial cost of attracting a client

Comparison of approaches to the calculation of CLV

Let’s try to understand the meaning of the CLV/CAC metric not in form, but in content.

1. What is the meaning of the CAC metric

CAC is the initial cost of acquiring a customer., the value of the life cycle of which we are trying to determine for ourselves. In this case, it is generally assumed that the duration of the customer life cycle will be more than one transaction for the purchase of your product and more than one operational cycle, ideally the longer the better.

It means that we can think of CACs as an initial investment in the profits or cash flow we hope to generate over the lifetime of an acquired customer, or in other words, we we can consider CAC as an initial investment in the client’s investment project.

When can we consider CAC as an investment rather than an operating cost, given that CAC is the cost of marketing, and not the acquisition of fixed assets or tangible assets? Is there anything in common between investing in tangible assets and investing in customer acquisition?

I think yes, we can find important analogies, and in particular:

1. the duration of the client’s life cycle, as a rule, is longer than the duration of one transaction with the client or more than one operating cycle, which is similar to the life cycle model of any investment project,

2. by carrying out expenses aimed at attracting a client, we we expect to receive the effect (profit, cash flows) from cooperation with this client for several periods of time and more than one operating cycle, which is also similar to the nature and model of an investment project,

3. by carrying out expenses aimed at attracting a client, we we pay back these costs most often within several periods of time and several operating cycles, which also corresponds to the nature and meaning of the concept of return on initial investment for any investment project.

In principle, we can consider CAC as an investment even if the transaction with the client is one-time and unique. Just in this case, the cash flow for the client will be one-time and will be limited by the duration of the transaction. But this is a special case.

2. Payback period for customer acquisition CAC (CAC Payback Period)

It is obvious that, by carrying out the costs of the SAS, we want to recoup these costs in one way or another. Otherwise, it is difficult to understand the economic meaning of such costs.

Therefore, when it comes to customer acquisition costs, we need to understand the payback mechanism of these costs and the expected payback period.

The cost recovery mechanism for attracting a client is the sale of the company’s products to the client, and the profit received from these sales should recoup (cover) the initial costs incurred to attract the CAC client.

The question remains open whether we will be able to recoup the cost of attracting immediately after the first transaction with the client and, if not, how many periods of time, how many operating cycles will we need for this.

Typically, to calculate the payback period for attracting a customer, investment metric of the payback period – CAC Payback Period.

This means that the task of determining the payback period of the CAC can be considered as the task of calculating the payback period of the initial investment in the client’s investment project, and the CAC payback process itself has the same nature as the process of payback of the initial investment for any other investment project.

Accordingly, if the payback period for attracting a CAC client involves more than one operating period, SAS costs are essentially of an investment nature, which means that a client attracted at the expense of such costs can be considered as an investment project.

3. The payback period can be calculated in two ways

From investment analysis it is known that the payback period of the initial investment of any investment project can be calculated in two ways – in nominal dimension (i.e. based on actual cash flows) and taking into account the time value of money (i.e. discounted).

When calculated in nominal dimension we simply compare nominal operating and investment cash flows, and when the net operating cash flow cumulatively exceeds the corresponding initial investment, we consider that the investment has paid off.

When calculating the payback period, taking into account the time value of money (i.e. using discounting) we need to recalculate nominal cash flows into discounted ones and determine the period of time when the discounted operating cash flow cumulatively becomes greater than the investment one.

Thus, to calculate the CAC Payback Period, you can use both methods of calculating the payback periodknown from investment analysis, and as the basis of the customer life cycle model, we can use the investment project life cycle model.

4. What is the meaning of the CLV metric

If we are ready to use the life cycle model of an investment project as the basis for the client life cycle model, then what prevents us from determining the value of such an investment project in the same way as it is customary to do in investment analysis, namely using the NPV metric?

As known from investment analysis the value of any investment project is determined by the NPV metric, those. as the net present value of the investment project, including the initial investment.

NPV can generally be defined as the difference between net reduced operating tributary Money And net present investment outflow funds of the investment project during the life of the project.

Considering CAC as an initial investment, and the CAC payback process is similar in nature to the payback process for the initial investment of an investment project, it is quite logical to conclude that for the investment project of the client, you can use the logic and metrics known from the investment analysis.

Then the value of the investment project client can be defined as

CLV = NPVc = PVc – CAC, i.e.

CLV can generally be defined as the difference between net reduced operating tributary cash for a client And net present investment outflow money for the client during his life.

If we consider CAC as a one-time initial investment in attracting a client, then it is obvious that discounting the initial investment of CAC is not required.

It remains to add that, by analogy with the payback period metric, which can be calculated both in nominal terms and taking into account the cost of money over time, depending on the goals and the task being solved, The CLV metric can also be defined in two ways – in nominal terms and taking into account the time value of money.

Then, if we consider the client as an investment project, the CLV metric can be analytically expressed in two ways:

1) taking into account the time value of money (with discounted cash flows)

CLV = NPVc = PVc – CAC, where

NPVc is the net present value of the customer’s cash flows over the lifetime of the customer,

PVc is the present value of the customer’s operating cash flow over the lifetime of the customer.

2) in nominal dimension How

CLV = CMc – CAC, where

SMS – marginal profit for the client, received during his life.

It is worth paying attention to the fact that in this case it is not so important whether we take into account the value of money in time or not, it is more important that when determining CLV from the point of view of the investment approach, it is necessary to take into account both operating and investment cash flows (expenses) for the clientwhich means that when calculating CLV, in the general case, it is necessary to subtract the initial investment of CAC from the total operating cash flow for the client.

5. Why does the CLV/CAS metric mislead us?

The problem is that CLV is defined differently in numerous publications and by different authors.

The meaning of the CLV/CAC metric depends on how you define CLV.

From an investment point of view the CLV metric, as I said above, must be defined as CLV = NPVc = PVc – CAC, or in nominal terms CLV = CMs – CAC. In this case the key is the need to include investment costs in the CLV calculation.

If you use a SaaS approach, the most commonly used definition is CLV = PVc, or nominally CLV = CMS. In this case the key is the lack of accounting for investment costs when calculating CLV.

Strictly speaking, there are other more sophisticated approaches to defining CLV, taking into account not only the value of cash flows for the client, but also non-monetary intangible components of the concept of customer value, but before using them in practice, it seems to me rational to first deal with simpler ones based on well-known financial and economic models.

It is in connection with the multivariance and ambiguity of the definition of the CLV metric that the CLV/CAC metric derived from it is misleading.

When it comes to using CLV/CAC metrics to make management decisions First of all, it is necessary to give a clear definition of the CLV metric.

Once again, we list the main approaches to the definition of CLV:

– Investment approach

CLV = NPVc = PVc – CAC (including initial investment CAC) or in nominal terms CLV = CMc – CAC.

– SaaS approach

CLVsaas = PVc (excluding initial CAC investment) or in nominal terms CLVsaas = CMc

– More complex models (taking into account the intangible value of the client)

6. CLV/CAC metric if using investment approach to CLV

If we use the investment approach to CLV, the CLV/CAC metric can generally be written as

CLV/CAC = NPVc/CAC = (PVc – CAC)/CAC.

In terms of meaning, this expression shows the ratio of the value of the investment project of the client NPVc (taking into account the initial investment in attracting the client) during its life to the initial investment in the implementation of the investment project of the CAC client.

Can this metric be used in practice? YES. In principle, you can use any derived indicators calculated on the basis of the primary data you have. The question is always why, what is the advantage of a new indicator compared to the existing well-known alternatives.

In investment analysis, the return on investment in an investment project is usually measured using the PI (Profitability Index) metric:

PI = Profitability Index = PV/IC, where

PV is the present value of the operating cash flows of the investment project,

IC – initial investment in an investment project.

Then for investment project client return on investment in customer acquisition can be expressed as

PIc = Profitability Index by client = PVc/CAC, where

PIc – index of return on investment in the client’s investment project,

PVc is the present value of operating cash flows from the client’s investment project.

7. CLV/CAC metric if using SaaS approach to CLV

In most cases, the CLV/CAC metric is used in the analysis and evaluation of SaaS projects. In this context, CLV is calculated as the total operating (adjusted or nominal) cash flow for the client during his life without taking into account the cost of attracting a client.

For clarity, let’s denote the CLV metric, in which the initial investment in customer acquisition is not taken into account, denoted as CLVsaas

CLVsaas = PVc

or in nominal dimension

CLVsaas=CMc.

Then, according to the meaning for the SaaS approach The CLV/CAC metric is the ratio of the total operating (adjusted or nominal) cash inflow for a client over the lifetime of the client to the investment cash outflow of the client’s investment project (i.e., the cost of attracting this CAC client), which, in terms of the investment approach to CLV means

CLVsaas/CAC = PVc/CAC = PIc = Profitability Index by client

PIc = Profitability Index by client

Let’s focus again that in the general case, if we consider the client as an investment project

CLV = NPVc = PVc – CAC ≠ CLVsaas = PVc

The CLVsaas / CAC metric in terms of the investment approach to CLV is the Profitability Index for the clientwhich means that by meaning and in the general case

“CLV/CAC”=CLVsaas/CAC=PVc/CAC=PVc/IC=PIc

As a conclusion

1. Depending on the context and the problem being solved CLV can be defined in several ways. This means that CLV/CAC is not a universal metric that depends on the selected CLV definition, which means that when using different CLV definitions, the CLV/CAC metric can have a different value, which makes it difficult to compare and analyze the CLV/CAC metric.

2. Comparing the cumulative and long-term effect of a relationship with a client over its life cycle with the initial cost (investment) of attracting a client allows us to consider the client as investment project.

3. In finance and investment analysis, a certain list of metrics already exists and is used in practice for evaluating, analyzing, comparing investment projects and making managerial decisions.

4. In finance and investment analysis in the general case, the value of an investment project is understood as the NPV metric, which is universal, does not depend on the nature of the project and allows you to compare any investment projects with each other.

5. NPV metric by definition and in general represents the difference discounted net operating inflow Money And discounted investment outflow of funds during the life of the investment project. Those. in finance and investment analysis, the project value metric takes into account and includes the investments necessary for the implementation of the project.

6. If we consider the client as an investment project, the value of the investment project the client should be determined as

CLV = NPVc = PVc – CAC

7. Typically, the CLV/CAC metric is used to evaluate and analyze SaaS business projects, where, by definition, CLVsaas does not take into account CAC, i.e. in fact, for SaaS, CLV means

CLVsaas = PVc

and then CLV/CAC means

CLVsaas/CAC=PVc/CAC.

8. If we use the investment approach and consider the client as an investment project, the CLV/CAC metric is PIc (Profitability Index) of the client’s investment project and should be calculated according to the formula

“CLV/CAC” = CLVsaas/CAC= PVc/CAC = PVc/IC = PIc = Profitability Index by client as investment project

9. Metric PI (Profitability Index) by definition and in general is a relation discounted net operating inflow Money And discounted investment outflow dfunds during the life of the investment project. Those. in finance and investment analysis metric PI is not a difference, but the ratio of the same indicators that are used in determining NPV.

10. Thus, given the proposed logic and meanings, we can conclude that CLV/CAC metric generally means known from investment analysis PI metric (Profitability Index), if we consider the client as an investment project.

12. Do not forget that depending on the problem being solved and the available data in some cases, including to simplify calculations and better understand processes, nominal values of metrics and cash flows can be used instead of discounted.

13. For clarity, the above reasoning and conclusions are presented in the form of a diagram in the infographic below: