Valuations of private companies have grown significantly over the past several years, according to a recent report by PitchBook Data. Private equity firms seem to be paying more in dollars terms to invest in or acquire companies, and also paying higher multiples of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), meaning business owners may be better rewarded for the profits they produce.
If you’re considering a sale or planning to seek a strategic investment of your business, it can make sense to maximize its value beforehand. While there may be many ways to increase your company’s valuation, one formula that can be especially helpful is the ratio of the long-term value of a customer to the acquisition cost of a customer, or “LTV/CAC.”
Many investors use this ratio to calculate the long-term growth potential of a business. Companies with greater growth potential can sometimes see significantly higher valuations when it comes time to pricing the business.
Calculating the LTV/CAC Cost Ratio
Sales, profits and recurring cash flows can all be derived from one source: customers. A valuable company should be able to show that it can consistently acquire new customers. It should also show that it can acquire these customers profitably.
That's precisely what the LTV/CAC ratio communicates.
Other metrics like revenues, profits and even cash flow can sometimes be misleading. A company can show growth in the number of customers or revenues without generating the expected profits. Or it could show healthy profits on an individual sale but must spend massive amounts in marketing to acquire new customers, making long-term profitability murky. The LTV/CAC ratio provides a standard method for determining the profit a company makes from a customer and compares that to the cost of acquiring that customer. A high LTV/CAC value can mean a business generates significant profits from each customer it acquires. That’s the type of business investors tend to love.
There are several ways to calculate this formula. I’m using a standard method, which should apply to most companies. I suggest using figures from the last 12 months of data instead of the last calendar year to provide a more current picture.
1. Collect This Information
- AR = Average revenue generated per customer account for the period
- AG = Average gross margin percentage on sales per customer account for the period
- TSM = Total sales and marketing expenses for the period
- CUnew = Number of customers added during the period
- CUlost = Number of customers lost during the period
- CUbeg = Total number of customers at the beginning of the period
2. Plug Them Into This Formula
LTV/CAC = [(AR*AG)/(CUlost/CUbeg)] / (TSM/CUnew)
If your business has multiple product lines or customer types (retailers and wholesalers, for example), you might want to calculate this formula for each product line or customer type as well as for the overall company. This can help provide a more accurate picture of where your company’s long-term potential lies.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.
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