Using LTV to Compute a Name Value

The lifetime value chart shown in Table 5-2 is typical of standard lifetime value charts. The details of such charts are spelled out in Chapter 4. A lifetime value chart has many uses. It can be used to determine

• How much to spend on acquisition of customers

• How much to spend on retention programs

• How much to spend on referral programs

• The payoff from particular marketing strategies

• The rental value of a name

• The value of a company, based on its acquired customer base

• Which groups of customers you should try to retain, acquire, or discard

• And many other things

Let’s try to determine the value of a name in a business-to-business setting. Assume we have a company that sells chemicals to industrial users. Let’s call our company WardChem. We have about 45,000 customers who spend from $5000 to $500,000 per year on chemicals. The average order is $2500, and the average customer buys from us eight times a year. Later we will break our customers down into segments (low-volume, medium-volume, high-volume, etc.), but for now, we will lump them all together into a single lifetime value table (Table 5-6), so that we can understand the principles involved.

Table 5-6 : Lifetime Value for Wardchem

	Year 1	Year 2	Year 3
Retention rate	70%	75%	80%
Retained customers	45,000	31,500	23,625
Average order	$2,500	$2,700	$2,900
Orders per year	8	9	10
Total revenue	$900,000,000	$765,450,000	$685,125,000
Cost rate	75%	71%	69%
Variable costs	$675,000,000	$543,469,500	$472,736,250
Acquisition cost ($1,400)	$ 63,000,000	0	0
Retention costs ($90/yr)	$ 4,050,000	$ 2,835,000	$ 2,126,250
Total costs	$742,050,000	$546,304,500	$474,862,500
Gross profit	$157,950,000	$219,145,500	$210,262,500
Discount rate	1.01	1.09	1.17
Net present value of profit	$155,779,959	$200,894,344	$179,159,636
Cumulative NPV of profit	$155,779,959	$356,674,303	$535,833,940
Lifetime value	$3,462	$7,926	$11,907

We are assuming newly acquired customers in year 1 and examining their performance over the next 3 years.

• The retention rate is the percentage of customers that remain from year to year. As we can see, WardChem loses 30 percent of its newly acquired customers after the first year. It does better in subsequent years, with the retention rate rising to 80 percent in the third year.

• Retained customers are those same customers in their first, second, and third years with WardChem. New customers who arrive in year 2 or year 3 are not shown here. The year they arrive is their year 1. Let us assume that WardChem retains a base of about 45,000 customers. It does this by losing 9000 customers and gaining 9000 new ones every year. We are studying the history of the retained customers.

• The average order size tends to grow every year. This is typical of all corporations.

• The number of orders per year also tends to grow.

• The cost percent is a rough number that estimates the average percentage of the selling price of company products that goes for manufacturing, distribution, and other costs. The balance is profit or marketing costs.

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• The acquisition cost is computed by adding together all the expenses involved in acquiring new customers during a given year—advertising on TV, radio, print, and direct mail; sales force salaries, commissions, and bonuses—and dividing that total by the number of customers actually acquired during that year.

• The retention costs are those costs spent to keep customers happy and buying. This could include an annual retreat, customer communications, or customer services.

• The discount rate is used to compute the net present value of the profits received. Money that will arrive in 1 year or 2 years is obviously not as valuable today as money that arrives today. The discount rate is a number that puts all these amounts on the same basis so that they can be added together. As discussed in earlier chapters, the formula for the discount rate is

  D = (1 + i * rf)^{waiting time}

  In this formula,

  i is the interest rate that the company pays for money

  rf is the risk factor (the risk that the money will not materialize at all)

• The waiting time is the length of time you have to wait before the money arrives. With consumers, this is usually 0 for the first year, 1 year for the second year, and so on. With business-to-business selling, the picture is different. Most business-to-business customers pay in 30, 60, or 90 days. So the waiting time is determined by adding these periods to the years.

  Table 5-7 is a simple chart that is used for calculating the discount rate of a business-to-business situation.

  Table 5-7 : Discount Rate Calculation

  	Year 1	Year 2	Year 3
  Years to wait	0	1	2
  Interest rate	6.80%	6.80%	6.80%
  Risk factor	1.1	1.1	1.1
  Accounts receivable days	70	75	80
  Discount rate	1.01	1.09	1.17

• The net present value of profits is the gross profits divided by the discount rate.

• The cumulative NPV of profits is calculated by adding the profits from previous years to this year’s profits.

• The customer lifetime value is calculated by dividing the cumulative NPV of profits in each year by the total number of newly acquired customers—in this case, 45,000. In this example, newly acquired customers are worth $11,907 in their third year with WardChem.