Frequently Asked Questions
As a ‘back of the envelope” calculation for one client:
Estimate the profit for the engagements you expect to have with the client over the period you expect to do business with him or her. If this is an unknown long term, use five years.
For example: If your average profit from a client on retainer was $10,000 per year and you expected to do business with that client for five years the CLV for that client would be $50,000.
Although this rough calculation is better than nothing, it doesn’t take into account a couple of significant variables – the discounted value of money in the future and potential risk that the client will defect.
Method of calculating CLV for the firm:
We like to use a discounted cash flow method of calculating client lifetime value because money collected today is worth more than money collected in the future. We also like to use an infinite time horizon because the use of a retention rate will account for the average customer lifespan.
In order to accurately calculate the CLV we need to know the average retention rate of clients at the firm. Simply put, retention rate is the percentage of clients who stay with the firm year over year. We recommend using a three year average for client retention rate.
We also need a discount rate to apply to the future cash flow. The discount rate is the value of the money in the future. This is typically determined by using the rate of return you would have received from that money if it was invested in a low risk investment vehicle - rather than sitting in your client’s pocket.
The calculation then looks like this:
- CLV = P x [r /(1+d– r)]
p = profit
r= retention rate
d= discount rate
So if we had an average client profit of $10,000, retained 80% of our clients and used a discount rate of 5%, the calculation would look like this:
- CLV = $10,000 x [.80 / (1+.05-.80)]
So for this firm the lifetime value of a client is $32,000.
This may seem like a complicated calculation but once you become familiar with the thinking behind it, the calculation becomes second nature. We are looking to determine how much money our typical (average) client will be worth to the firm. It is the long term thinking that is as important as the actual calculation itself.