The Role of the Discount Rate in CLV

 

What does a discount rate do?

Discount rate converts future cash flows (that is revenue/profits) into today’s money for the firm. For example, if you put $100 into a bank account today that have 10% interest, then in 12 months’ time you would have $110 in the bank. In this case, $110 next year is equivalent to $100 today.

The same principle applies to a firm, where they have the ability to invest its available capital into its business operations. If a marketing forecast identifies that a project/campaign will deliver a positive cash flow of $1.10m at the end of the first year, then this is the same as the firm investing $1m into their normal business operations today (that is, present value, using the 10% return above).

Therefore, the discount rate considers what the future profits from a marketing campaign/project are equivalent to today if the funds where invested in the firm’s normal business operations.

Time is a factor

The longer into the future the customer’s revenue is expected to run; the more each year is discounted. This means that projected revenues in 20 years’ time only have a small contribution to make to customer lifetime value.

This is an important consideration for two reasons:

  1. The dollar value is not as high in the future, as illustrated by the bank interest example above, and
  2. There may be uncertainty associated with the future of a consumer’s cash flow.

Why is there uncertainty?

While we have a pool of quite loyal customers that allows us to be quite predictive and accurate over a 3 to 5 year horizon, there are significant challenges going forward. For example, we have competitive activity in the emergence of new competitors; we also have changing customer lifestyle preferences, changing technology and environmental issues and so on.

Simply think about the dynamic change in the business landscape with the advent of internet. Prior to the internet, large newspapers would have believed that their customer base (and customer lifetime value) would be very stable and easy to forecast – they thought it would continue on uninterrupted. Therefore, they were predicting an average 30 year loyalty per customer without considering a discount rate, they would have very high an unrealistic customer lots of values.

Therefore, a discount rate serves two purposes – to adjust for the future value of money into factor in the uncertainty of the marketing environment. Depending on the firm that you work for – they may require a more aggressive discount rate to be used OR their normal discount (hurdle) rate along with a range of scenarios developed for the marketing forecast as a form of sensitivity analysis.

Related Topics

What discount rate to use?