The ratio of Customer Lifetime Value (LTV) to Cost Per Acquisition (CPA or CAC) is one of the most important commercial metrics for any business. It represents the fundamental unit economics of customer acquisition and how efficiently a business is able to grow. In simple terms it is the return on investment (ROI) of marketing spend.
In spite of this, in my experience most Management teams of small and mid-market businesses have never calculated it. You can understand why, as there is often a lot of setup analysis involved. As a task, this almost always falls into the 'important but not urgent' category and struggles to get to the top of your to-do list. Instead, marketing efficiency is calculated using CPA on its own, or perhaps by looking at marketing spend as a % of revenue.
However, once you step in the investment world, the LTV:CPA ratio is favoured by bankers and private equity investors, often having a prominent position in Management presentations and sales documents. This is because it is both easy to understand for non-marketers and highly comparable both within and between market segments.
For investors looking to assess future growth potential, a lot is inferred from the LTV:CPA ratio, making it important for all Management teams to understand well ahead of any investment process.
For any investor, I would also recommend probing the basis of each metric rather than taking a quoted LTV:CPA ratio at face value. In my experience, when this ratio is calculated as part of an investment process, there are normally some shortcuts taken which unsurprisingly can result in an overstated ratio (for example, using considering customer revenue rather than customer profitability for LTV). I've compared some real-world LTV to CPA ratio examples in another post to help you do this.
The LTV:CPA ratio will tell you the ROI of marketing spend in the time period over which Customer Lifetime Value is calculated, normally 3 or 5 years. One alternative metric which uses the same inputs is the Payback Period, normally quoted as the number of months it takes for a customer to generate profit equal to the initial CPA.
It is helpful to consider both metrics so that you understand the ‘J-Curve’ of customer acquisition - how long a business will be ‘out of pocket’ at both profit and cashflow levels after spending to acquire a customer. Whilst most Management teams are happy to invest to accelerate growth, there is often a constraint on cashflow or a minimal level of in-year profitability required.
What is a good LTV:CPA ratio?
As described in my introduction to Cost Per Acquisition, CPA is a metric which will typically increase as a business seeks to drive more demand (i.e. you will see diminishing returns) - you could think of it like a supply curve. This means that the LTV:CPA ratio will narrow as a business grows faster, all things being equal. We therefore need to consider the LTV:CPA ratio in combination with growth rate.
For businesses experiencing good double digit annual growth, say 20-50%, I’ve seen 5-year LTV:CPA ratios mostly in the 3:1 to 5:1 range.
If the ratio is above this level, there is normally potential to accelerate growth by investing more in marketing.
If the ratio is at the bottom end of this range or even narrower, this is often an indication of a very competitive market (e.g. travel or personal lines insurance), and/or an early stage business with lots of scope to optimise conversion and Customer Lifetime Value. This could also indicate some inefficiency in marketing spend which could be addressed to improve the LTV:CPA ratio.
How to use the LTV:CPA ratio
The LTV:CPA ratio can be set as a target by Management teams, and used to optimise marketing spend both between and within channels. It allows boards and Management teams to trade off short-term vs long-term profitability by adjusting the level of marketing investment and consequent growth rate (I’m going to talk about this in more depth in an upcoming piece). Using the ratio in this way is a key indicator that your marketing function is operating as a profit centre rather than a cost centre.
For example, if a business is working to a target LTV:CPA ratio of 4:1, the marketing and sales teams can optimise their activities to this level of ROI, with the growth rate will change as a consequence of these changes. One very important watch-out is that this ROI ratio should be implemented as a minimum ratio rather than an average. Using an average can mask a lot of inefficient marketing spend. Over time you can also apply your ROI target with increasing granularity. For example, if you are running Paid Search (PPC) activity, you might start using the target at a campaign level, then move on to ad group and ultimately at keyword level.
It is also important to make sure the input Customer Lifetime Value is frequently updated for any changes in business model or customer behaviour – for example if additional marketing investment starts to generate customers with a lower LTV this would be an important consideration.
If you’d like to discuss how you can better understand and use the LTV:CPA ratio in your business, please Contact Me.
All views expressed in this post are the author's own and should not be relied upon for any reason. Clearly.