The finance of customer retention strategy is often poorly understood. The explanation is simple. CFOs are not familiar with churn parameter in their profit and loss equation.
So, how could you know the impact of a lower churn on your valuation?
STEP1: introduce a Churn in your recurring cash flow
Here, we are modelling the recurring cash flow of a stable business. The recurring cash flow is defined as the Average Revenue Per User (ARPU) less the Cost To Serve (C2S) a customer and acquisition costs to maintain the number of customers (=Churn.CAC), and multiplied by the number of customers:
A traditional Gordon-Shapiro formula models the Market Value:
STEP2: calculate the sensitivity of the Market Value to the Churn
According to Bain, in financial services, a 5% increase in customer retention produces more than a 25% increase in profit. A sensitivity of 5 times the retention.
The derivative of the Market Value above is the following:
Dividing by the Market Value, you get the equation under:
The sensitivity of 5 would mean that:
Our experience of these metrics would tell us that the average sensitivity should between 2,5 and 5. The higher your return, the lower your sensitivity.
This table helps you to estimate your sensitivity depending on your specific metrics:
STEP3: if a higher churn decreases growth
In a more complex version, you can introduce a negative correlation between the churn and the growth rate. Because a lower quality of service generates a higher churn but also a lower growth.
A simple linear function would give you the following calculations:
You can calibrate the parameters a and b using 2 observations or estimations.
You could also deduct an optimal customer retention strategy from the equations above.
Nota Bene: You are free to share this article! Thanks in advance. Damien