Customer acquisition cost (CAC) and lifetime value (LTV) are vital eCommerce and SaaS metrics that companies use to measure how much investment is required to acquire a customer’s patronage and how much recurring revenue that person will likely provide.
On their own, either metric provides analytical value. But when compared to one another using an LTV/CAC ratio, you can perform a cost-benefit analysis to determine whether your efforts are, indeed, providing worthwhile value.
But what is a “good” LTV to CAC ratio? How is this figure calculated? And what steps can you take to improve it?
What is the LTV to CAC ratio and why does it matter?
The LTV/CAC ratio is one of the most critical indicators of future success. This is why it’s one of the key calculations prospective investors use to determine a company’s valuation.
While the ratio can convey a variety of pertinent information about the actions of the company and its customer base, at its essence, LTV/CAC quantifies how efficiently your company is utilizing its resources. It does this by comparing the cost to acquire the new customer relative to the value and profitability that the customer provides.
But why does this matter?
The LTV/CAC ratio offers both internal and external analysts a snapshot of the company’s efficiency and potential value. Generally speaking, a sub 1.0 ratio indicates that a company is losing value while a ratio that is greater than 1.0 indicates that the company is creating value:
A high LTV/CAC ratio – Demonstrates that your company is capable of attracting new customers and maintaining a high customer retention rate for little cost. Therefore, your company is primed for rapid growth and has less need for outside investment.
A low LTV/CAC ratio – Demonstrates that your company is operating inefficiently. To grow, you’ll require outside capital injections. But this will reduce your valuation and make you a less attractive investment target.
On the surface, a low LTV to CAC ratio may be a negative indicator. But that’s not always the case. According to Lighter Capital:
“The exception to the rule that a low ratio indicates potential trouble is the early growth stage of a SaaS startup. You are forced to spend a lot to acquire your earliest customers, as you haven’t yet built up a track record, cultivated word-of-mouth, or been able to expand your business with existing customers. When your customers’ lifetime isn’t yet very long because you’re new, your LTV will be low by nature.”
On the road to success, a SaaS business will eventually increase its LTV and lower the CAC over time. So, as they continue to establish a foothold in the marketplace, their ratio should steadily improve.
What is a valuable LTV to CAC ratio?
There’s no magic number for the perfect LTV/CAC ratio. It depends on your industry, your business, and where it is in its lifecycle. At the very least, you’d like the ratio to be higher than one. When that’s the case, you know that the value a customer offers is greater than the customer retention cost.
Most financial analysts and economists suggest that a ratio of 3:1 is a solid benchmark. At this point, a customer would be providing 3x value for the cost of each acquisition. And while there’s some flexibility in the ratio, too much or too little could signal that there are underlying problems.
For instance, an LTV/CAC that’s higher than 5.0 could mean that you’re not spending enough on new customer acquisition. And for early-stage companies, revenue and user growth is far more important than reducing costs. So, if your ratio is too high, you may be missing out on significant growth opportunities.
Investors use this metric to gauge your company’s health. It tells them how fast, and by how much, the company should expect to grow. It also lets them know the predictability of your expansion revenue streams. This knowledge can then be leveraged to inform your strategic improvements to the business model and to help investors determine whether you are a sound investment.
To get the most value from the metric, it’s better to track it over time. Trends help you visualize which adjustments are helping or hurting. But remember to be patient when making changes, because the shift in the ratio often has a time lag.
Common causes of a Low LTV/CAC Ratio
If your ratio is at 1.0 or less than that, your company teeters on the break-even point. Should you wish to grow, there may be some adjustments that need to be made before you try to scale or acquire outside investment. Common reasons for a low ratio include:
A too broad strategy – If your sales and marketing strategy is too broad, you may end up wasting resources targeting people that are too far outside of your optimal user. This is why it’s important to conduct extensive market research, build consumer personas, and then build a marketing strategy bespoke to the target audience.
A vague target market – Similarly, if you target a market where demand simply doesn’t exist, you’ll gain little traction in the market, making it incredibly difficult to grow.
Poor budgeting – If your budget is apportioned to ineffective sales and marketing efforts while impactful avenues remain underfunded, you could be missing out on significant opportunities to reach and convert new customers.
If you have addressed these potential issues and still have a low LTV/CAC ratio, it could indicate that there are fundamental structural issues regarding monetization and the product’s market fit.
How do you calculate this?
To determine your ratio, you need to start with the numerator, lifetime customer value, which measures the total cash flow a customer will bring over the duration of their relationship with your business. Naturally, the longer a customer stays a customer, the more valuable they become.
The customer lifetime value equation may look different depending on the company:
- SaaS LTV = Gross margin % x (1/monthly churn) x average monthly subscription per customer
- eCommerce LTV = Average volume of sales x number of transactions x retention period x profit margin
So, for example, if you were a SaaS company and had a gross margin of 60% and a monthly churn of 3% and each customer spent an average of $25 per month, the figure would look like 60% x (1/3%) x ($25) = $500 LTV
Once you have determined the customer’s lifetime value, you then move on to the cost of customer acquisition. This is calculated by dividing your sales and the total marketing cost by the total number of new customers acquired.
So, if you have monthly sales and marketing expenses of $100,000 and acquired 400 new customers it would be a customer acquisition cost of $250. A $500 LTV divided by $250 CAC gives a 2.0 LTV/CAC ratio.
That’s a decent figure, but it could be better.
The importance of segmentation
To derive the most value out of this analysis, most companies will take it to a more granular level via customer cohort analysis. With this methodology, instead of looking at an average customer across the board, customers are segmented according to factors like demographics or year of acquisition. In doing so, you can get even more actionable insights about:
- Where marketing and sales spend should be allocated
- Which customers provide the most value
- Which customers are the cheapest to acquire
- Whether the current business model is viable
By digging down into your customer data, you can then create a more targeted and personalized marketing and sales strategy. Additionally, it provides an opportunity to either ditch an ineffective channel altogether or pivot within that channel. These efforts should help improve your LTV/CAC ratio.
About Power Digital:
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