Paid advertisements are a highly popular, often effective strategy to increase website traffic and grow your startup. They are also a great way to lose money. As founders, how do we know when paid ads will work for our business? We need to understand our return on investment for a marketing strategy with many unknowns. Try using this simple strategy to estimate your ROI on paid ads before you make the investment.
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1.) First, establish a monthly budget for paid advertisements. In this example, I will use $5,000 based on my hypothetical financial model.
2.) Determine your cost per click (CPC).
If you don’t already know your cost per click, you can get a fairly realistic estimate by searching your keywords in Google or through Facebook Ads.
3.) Estimate expected website traffic based on your budget
Budget / CPC = Paid Traffic
If my budget for paid ads is $5,000 and my estimated cost per click is $3, my expected paid traffic is 1,667.
4.) Estimate a conversion rate for your paid traffic
Either research average conversion rates on the internet or connect with experts in your space that already use paid advertising. Check out these resources from Wordstream and Smart Insights to jumpstart your estimate. In this example, I am using a conversion rate of 2%. This estimate may change as you experiment with paid ads, but also provides a helpful KPI to measure the effectiveness of your ad strategy.
5.) Determine number of new customers acquired through paid ads.
Paid traffic * conversion rate = new customers
This provides a rough estimate on new customer acquisition you should expect using effective ad strategy. In this example, my paid traffic is $1,667 * my 2% conversion rate, generating 33 new customers per month.
6.) Calculate the average lifetime value of your new customers
You need to collect three inputs for this calculation.
a.) Average revenue per customer per month: For subscription based services, determining the average monthly amount per customer that you charge is easy. For other types of businesses, select the average monthly revenue per customer.
b.) Monthly customer churn: Determine the percentage of your customer base that you lose every month.
c.) Gross profit: Determine average percentage "profit" per customer - take out cost of goods sold (direct costs) like payment fees, hosting, and customer support.
With these inputs in mind, calculate average lifetime value (LTV).
LTV = (Average revenue per customer per month / Monthly Churn) * Gross profit
In our example, we earn $10 a month from each customer. We lose 7% of customers a month. We determined gross profit is 80%. As such, we calculated our average lifetime value of a customer: LTV = ($10 / 7% ) * 80% = $114.29
7.) Determine cost to acquire a customer (CAC). CAC = Budget / New Customers In step 1, we determined our budget was $5,000. In step 5, we calculated 33(.33) new customers per month. As such, our cost to acquire a customer is $150.
8.) Should we use paid ads?
If the lifetime value of a customer outweighs the cost to acquire a customer, we will earn a profit on the advertisements. In this example, our LTV of a customer is $114.29. Our cost to acquire a customer is $150. It does not make sense for our business to purchase paid ads.
If LTV - CAC is positive , use paid ads. If LTV - CAC is negative, you will lose money on the investment.
Download our simple Paid Ads ROI Tool (below) to project your success and determine whether paid ads are a good investment for your startup.