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The term recurring revenue comes from the word “revenue” because it implies that this type of income is repeated over time. Some types of business model achieve this with a monthly subscription, for example. Or they may have you pay them up front to use their service (like hiring an accountant), but then they charge you per use after that.
Another way they can create this effect is through a paid membership or VIP account. For instance, if you are looking to connect with other professionals, you might be asked to pay a fee to join. This fee typically goes towards your memberships at the other professional services companies in their lineup.
The second step in determining how much money you make per hour is calculating your Customer Lifetime Value (CLV). This is an important metric to calculate because it determines how expensive of a product or service you have to sell before making a profit.
Your CLV is calculated by taking one final piece of data and applying it to our initial cost-per-hour calculation. That data is average purchase amount.
By figuring out how much people spend on your product or service, we can determine how valuable your product is to them. By dividing this number by time spent using the product, we get their Average Life Time Value.
The average life time value of a person using your product for one year is $100. People who use your product for a month are 1/30th as valuable ($3) as those that use it for a whole year!
If we take our restaurant’s example again, this would be like asking why they don’t make more money during the lunch rush season instead of winter off season. Sure, they could try to keep up with demand then, but what about all the other parts of the business? You need to consider things such as employee morale, motivation, and productivity at these times.
You want to reward them for hard work so they keep doing it! And since people usually eat vegetables while eating food, we know that investing in good health will help promote that growth.
A more accurate way to calculate return on investment is to look at it not as how much money you make, but instead what your business makes in profit per unit of time. This metric – called the cost-per-conversion (CPC) ratio – changes based on the length of time you have for conversions, or spending on advertising to draw in new customers.
If you only have a short amount of time before your product runs out then your CPC ratio will be very high. You’ll need to increase the price you charge to attract new clients, which could scare away potential buyers.
On the other hand, if you have access to the same resources and products your competitors do, then your CPC ratio will drop. You can use this information to determine the best pricing for your own product and services.
With an annual recurring revenue model, you get continuous income every year without requiring large upfront costs. Because there are no one-time purchases, your cost per conversion is lower than if you were using a one-time purchase model.
The second part of this formula is calculating your customer growth rate. This can be tricky since you will have to make assumptions about how many customers you have at any given time.
You can use either an exponential growth curve or linear growth curve. With exponential, it calculates the percentage increase by taking the difference between two numbers divided by one number. Using our examples above, this would look like this: (5% – 2%) / 2%.
With linear growth, it looks at the ratio of addition over total amount. In other words, if there are three people working for a company, then they add a fourth employee, what does that do to the length of the work day? It lengthens it!
We can apply this concept to business growth. If we assume that during our starting year, we had 1 customer per week, then what happens as we grow and get more customers? More hours in the day!
The longer we have been offering our service, the faster we grow so naturally, the growth comes down to how much we added on to last year’s revenue. We can calculate this using ratios!
Using ratios to determine growth
For example, let’s say that last month was twice the size of this month. That means we doubled our sales which brings us closer to doubling our revenue each month.
However, we cannot just double our revenue each month because we also need to maintain our current level of production.
The next step in calculating your CMR is determining your customer retention rate (CR). This is the percentage of time customers will spend paying you for your product or service.
Most companies use what’s known as the Kaplan-Mueller method to calculate CR. The Kaplan-Muller method calculates two different rates, one for initial purchases and another for repeat purchases.
The initial purchase ratio comes from dividing how long it took to get that first sale by how much time passed since then. The repeat purchase ratio comes from dividing how many times people reordered the product within a given period by how much time has elapsed since their last order.
You can find average CRs online, but the best way to determine yours is by comparing yourself to competitors. Find out who else is drawing in new revenue and compute their CR relative to yours to get a good idea.
The next step in calculating ARR is to calculate your average order value (AOV). This is simply the total amount you have received for each product divided by the number of days since your launch.
For example, if one of your products has been on sale for the past week then its AOI would be 1 day less than it was before. Its AAR would also be adjusted by this difference.
So instead of having $100 per month in revenue, we’d now only have $90 per month!
This seems very drastic but it makes sense when you think about it. We are assuming that sales will stay at their current level until the end of the year, which is always a strong assumption unless there is a dramatic price drop or an urgent need to move out fast.
By taking into account any discounts or AOIs, we can determine how much money you make per month really well. And remember, these numbers will fluctuate seasonally so try to pick times with enough data to give you reliable results.
The next step in calculating annual recurring revenue is to calculate your revenue growth rate. This can be tricky, as not all of your products are made equal. Some may have higher profit margins or lower pricing, which would influence how quickly their revenue grows.
It’s best to use average price increases for items that you sell frequently to get an accurate picture of how fast your business will grow. For example, if you sold a book every month, we could assume it has a high margin, so we can use the average increase in sale prices to determine the growth rate.
On the other hand, if your product has a low margin and costs a lot to make, then we cannot simply take the average cost hike to determine growth. Because of this, we must also include the proportion of sales that returned a loss in the calculation.
This way, we create an equation that calculates both the average price increase and the ratio of losses, which when multiplied together gives us our revenue growth rate.
The next step in calculating the company’s intrinsic value is to determine how much money you should allocate for each of the following categories: current revenue, future revenue, cost of goods sold (COGS), research and development (R&D) and marketing.
Current revenues are straightforward – add up all of the monthly recurring revenue that your business has right now. This includes both internal services like Unlimited Plan subscriptions or software packages that users have paid for previously.
Future revenues refer to what your business plans to do with its products in the coming years. If you plan to keep offering the same service level indefinitely, then this can be included as an increment into the total marketable value of the company. However, if your business has planned relaunches or new product offerings, these need to be accounted for separately.
Add up the costs listed above and see whether it makes sense to include them as part of the final price. For instance, COGS will likely be shared across different products so this can be calculated and allocated proportionally.
The final important factor in determining the overall company value is R&D which covers things such as developing new features or technology, negotiating license agreements and investing in equipment and resources needed to run the business effectively.
Importantly, remember that no matter what type of business you own, you must maintain an adequate level of spending to remain competitive.
When it comes to determining the value of a business, there are two main approaches. The first is what’s called the market approach. This calculates the price that a buyer would pay for the business in an open sale. By looking at similar businesses and estimating what they're sold for, you can come up with a valuation.
The other method is the income-based approach. Here, you calculate the value by multiplying the company's net profit by a capitalization rate (the percentage used to convert net profits into cash). A common net profit metric is earnings per share (EPS), which looks at both revenue and profit per share.
This calculation assumes that future income will keep the business profitable and increase its buying power. It also assumes that this income will remain consistent, or at least grow consistently. If not, then the valuation may be overestimated.
It's important to remember that sales do not necessarily make a business more valuable. For example, if a business has very little profit but high revenues, then investing in that business could cost you money because you'd be giving away profits.
