CUSTOMER LIFETIME

VALUE (CLV)

Ravi Agarwal
 Content
 Introduction
– Customer Lifetime Value Principles
– Motivations

 Customer Lifetime Value Modeling

– Approach
– Models Described
• A “Pragmatic Approach”
• The Pareto/NBD model
– An Example case study of hotel industry

 Conclusions and Summary 2

 Customer Lifetime Value

 For a firm, the customer lifetime value

(CLV or CLTV) is defined as the net of
the revenues obtained from a customer
over the lifetime of transactions with the
customer minus the cost of attracting,
selling, and servicing the customer,
taking into account the time value of
money (Berger and Nasr 1998).

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 Customer Lifetime Value
 The CLV of a customer i is the discounted value of the future
profits yielded by this customer

CFi ,t
CLVi  t 0
h

(1  d ) t
 Where
– CFi,t = net cash flow generated by the customer i activity at time t
– h = time horizon for estimating the CLV
– d = discount rate

 The CLV is the value added, by an individual customer, to

the company
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 CLV: A Simple Example

 The sum of the future profits yielded by this customer is 523

 Assuming a discount rate of 10%, the CLV at moment 0 is
398.11 5
 Financial Motivations for the CLV

In many businesses, the profits yielded by the

customers are the only earnings of the company

Gupta, et al (2006) have shown that the CLV of the

customer base (Customer Equity) is a key driver of
the stock value.

 As a financial analyst, knowing the CLV of the

customer base increase the knowledge on the focal
company.

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 Marketing Motivation of the CLV

By knowing the CLV of the customers, one can

 Focus on groups of customers of equal wealth

 Evaluate the budget of a marketing campaign

 Measure the efficiency of a past marketing

campaign by evaluating the CLV change it incurred

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 Commercial Motivation for the CLV
 By knowing the CLV, someone in a branch office
can
– Focus on the most valuable customers, which deserve to
be closely followed
– Neglect the less valuable ones, to which the company
should pay less attention

 At each decision level, to know the CLV allows to

make efficient actions.

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Customer Lifetime Value Modeling

How?
 An Applicable Solution

CFi , j ,t
CLVi  t 0, j 1
h, J

(1  d ) t
 Where
– CFi,j,t = profit yielded by the customer i, due to the activity related to
the product category j, during the time period t
– h = time horizon of the prediction
– d = discount rate
– J = number of products the focal company sells

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 The Time Horizon
 Theoretically, the horizon should be infinite. It is
unmanageable in the reality
– Long-term relationship is important
• Take a long horizon, e.g. 10 years
– Short-term relationship is important
• Take a small horizon, e.g. 1 year

In the empirical application, we will use a horizon of 2

years.

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 The Discount Rate
 Is theoretically unknown, but one could have a
reasonable approach, and choose it according to
the focal company policy
– Short-term relationship is important
• Take a high discount rate, e.g. higher than the WACC
– Long-term relationship is important
• Take a small discount rate, e.g. lower than the WACC
– Neutral
• Take the WACC of the focal company at the moment of prediction

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 The Number of Products Considered
 A multi-service (product) provider will sell several products.

 When predicting the future profits per product category

separately, the following problems could arise.
– Cross-selling: if the profits related to one product category increase
for a customer, another product category could benefit of this.
– Cannibalism: if the profits related to one product category increase for
a customer, another product category could suffer of this.

In the empirical application, we will not consider a multi-product

case. The customers will be considered as buying only one
type of product (hotel room).

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 The future profits
That is the tricky part. The future profits are harshly predictable.
However, one can generally find four approaches in the
literature. (topology of Gupta, et al 2006)
– RFM Models
• Create “cells” or groups fo customers based on the recency, the
frequency and the monetary value of their prior purchases
– Probability Models
• Assume an underlying stochastic model (e.g. The Pareto/NBD model)
– Econometric Models
• Typically: Hazard functions, Survival Analysis
– Persistance Models
• Typically: Vector Autoregressive (VAR) model

In Practice  A MIX

In what follows, we will present one of these approaches, the

Pareto/NBD model.
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 A Pragmatic Approach
 The net cash flow can be replaced as
( pi ,t  ci ,t )ri ,t
CLVi  t 0
h
 ACi
(1  d ) t

where
– pi,t = price paid by a consumer i at time t
– ci,t = direct cost of servicing the customer at time t
– ri,t = probability of customer i repeat buying or being alive at time t
– ACi = acquistion cost for the customer i
– h = time horizon for estimating the CLV
– d = discount rate

 Or, for the customers already acquired, with an infinite horizon and constant
retention rates,
ri
CLVi  mi
1  d  ri
where mi = pi-ci is the margin, assumed constant over time.

In the empirical application, we will take mi as the historical average for the customer
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i and r constant across customers with r = 75%.
Customer Lifetime Value Modeling

The Pareto/NBD Based Models

 Pareto/NBD: CLV Design
 With the transactions prediction approach, the CLV is
designed as

xi ,t  mi ,t
CLVi  t 0
h

(1  d )t
 Where
– xi,t = number of transactions yielded by customer i in the period t
– mi,t = profit per transaction yielded by customer i in the period t
– d = discount rate
– h = time horizon of the prediction

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 Model for the number of transactions
 The Pareto/NBD Model (Schmittlein et al. 1987)
– The activity time is exponentially distributed with an
individual “death rate” for each customer
– The “death rate” is gamma distributed across customers.
– While active, each customer makes purchases over time
according to an individual Poisson Process
– This Poisson parameter (purchasing rate) is gamma
distributed across customers
– These two rates are independent

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 Model for the profitability per transaction
 The Gamma/Gamma Model (Fader et al. 2005)
– The profitability per transaction of a customer is gamma
distributed
– The rate parameter of the above gamma distribution is
gamma distributed across customers
– The average profitability per transaction is constant over
time
– The average profitability per transaction is independent of
the number of transactions

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 Advantages of the Pareto/NBD based approach

 Requires only four variables (RFM approach)

– The frequency: the number of transactions in the past
– The recency: time units since last purchase
– The cohort: time units since first purchase
– The monetary value: the average profit per transaction

 Does not need a splitting of the training sample

– A regression approach needs one!

 Provides the probability of activity of a customer

(survival analysis approach)
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 Conclusions
 CLV Prediction is difficult because:
– The retention rate is unknown
– The future margin/profit per transaction is unknown
– The future number of transactions is unknown.

 But existing models give satisfying results:

– The “pragmatic” approach gives very good results at the
customer base level
– The Pareto/NBD approach gives very good results at the
individual customer level
 Both are useful
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 Select References
 Berger, P D and Nasr N I, “Customer lifetime value: marketing models and applications”,
Journal of Interactive Marketing, 12 (Winter), 17-30, 1998

 Gupta, S., Hanssens, D., Hardie, B., Kumar, V., Lin, N.,Ravishanker, N., Sriram, S.
“Modeling customer lifetime value”, Journal of Service Research 9(2), 139-155, 2006.

 Gupta S., Lehmann D. R. , and Stuart J. A., “Valuing customer”, Journal of Marketing
Research, 41(1),7–18, 2004.

 Glady N., Baesens B., and Croux C, “Modeling Churn Using Customer Lifetime Value”,
submitted for publication.

 Peter S. Fader, Bruce G. S. Hardie, and Ka Lok Lee, “RFM and CLV: Using iso-value
curves for customer base analysis”, Journal of Marketing Research, 42(4):415–430, 2005.

 Schmittlein, D. C., Peterson, R. A., “Customer base analysis: An industrial purchase

process application”, Marketing Science 13 (1) ,1994.

 Schmittlein, D. C., Morrison, D. G., Colombo, R., “Counting your customers: who are they
and what will they do next?” Management Science 33 (1), 1987.

 Glady N., Baesens B., and Croux C, “A Modified Pareto/NBD Approach for Predicting
Customer Lifetime Value”, submitted for publication. 22