Why is Total Addressable Market Important?
Total addressable market (TAM), sometimes called total available market, refers to the entire revenue opportunity in a specific market. In other words, TAM is an estimate of the amount of sales that one firm would have if it had 100 percent market share. Understanding TAM is important for defining your company’s strategy and determining a valuation during all stages of a start-up’s life cycle.
Even before your start-up begins operations, a TAM analysis can help you identify opportunities and understand the competitive landscape of the market that you plan to enter. If a TAM analysis reveals that the TAM in a potential market is low, then your company may never generate significant revenues. Alternatively, if a market is large but already saturated with other competitors, then it could be difficult and costly to differentiate your company from the competition and become profitable. This is not to say that companies should not enter small or saturated markets. In the right circumstance it could be a worthwhile investment; however, understanding these factors before entering the market can help you develop a winning strategy in less-desirable market circumstances.
Without a sufficiently large TAM, venture capital firms are unlikely to invest in your company. Venture capital firms and investors use TAM to estimate growth potential. TAM is related to scalability—a company’s ability to increase revenues unimpeded by internal or external factors. Therefore, one of the first steps in identifying a company’s valuation is ensuring that the TAM is large enough to foster company growth and investor returns. Each investor will have a different definition of what a “large” TAM is, but most large investors will not invest at all if they estimate your TAM is too small.
Because of the overall importance of TAM, it will be a key component of your pitch to investors. A thorough and developed TAM analysis shows investors that you have the potential for growth, that you understand your business, and that you have a plan to achieve that growth. Even if your company is not looking for outside investment, a TAM analysis can still help you identify growth opportunities, understand competitive risks in your industry, and determine whether an opportunity is worthwhile for you to pursue as an entrepreneur.
After considering overall TAM, investors look at the percentage of TAM your company holds compared to the percentage of TAM that competitors hold. Table 1 illustrates the likelihood of receiving an investment based on those two factors:
While this table is a simplified version of investors’ analysis, it illustrates the concept that investors want to invest in companies with sufficient room for growth and lower levels of competition.
TAM Analysis Approaches
Three main approaches are used to calculate TAM: top-down, bottom-up, and value theory. Each approach will be illustrated below using Driverless Trucking Co. (DTC), a company that has developed driverless trucking vehicles serving a small number of retailers in the southwestern United States. While each approach will be described separately, it is important to note that companies will often use multiple approaches or a hybrid approach in order to further refine their TAM estimate.
The top-down approach begins by finding a large, known population published by a research firm. This larger market is then narrowed down to include only the specific markets that the company plans to target (see Figure 1). The advantage of this approach is that it is simpler, less costly, and can be used even before a company begins to generate revenue. However, the top-down approach is generally not preferred because it depends on the research of outside consultants and makes subjective assumptions and estimates. Additionally, it can be difficult to define the specific industry of a startup, especially for newer markets.
Example. Driverless Trucking Co. acquires the details of a research report that estimates global transportation revenues at about $4.6 trillion. The company determines that it will focus on the US trucking market which accounts for approximately 15 percent of the global transportation industry. Based on this data, DTC determines that its TAM is approximately $690 billion ($4.6 trillion x 15%). Remember that the final TAM figure in this and later examples measures projected revenue for 100 percent of the considered market—it is not a projection of DTC’s future revenues nor is it a valuation.
Professional research firms often publish broad industry data but charge steep fees to access information about more specific markets. Although these reports can provide a more disaggregated starting estimate for TAM, the cost often outweighs the benefit.
The bottom-up approach uses the existing operations of the company in its current market and projects that value to larger target markets (see Figure 2). The advantage of this approach is that the resulting estimate is more reliable because it is based on a proven data point. However, extrapolating a single data point to other markets may still be inaccurate due to unique individual market factors. Additionally, this approach often relies on additional outside data which could be difficult to obtain and may not be reliable.
Example. Driverless Trucking Co. currently charges $1.50 per mile, well below the current industry average of $2.00 per mile. Additionally, DTC logged approximately 2 billion miles in the most recent year compared to estimates of 440 billion miles for all trucking companies. Based on this data, DTC estimates that its TAM is approximately $660 billion (440 billion miles x $1.50 per mile).
DTC could also take this analysis a step further by trying to estimate how much the decreased costs in trucking would increase the size of the market. As DTC’s technology decreases the cost of trucking, more companies can be expected to use trucking to ship products instead of other modes of transportation. Including the effects of the company’s actions on the overall market can be informative; however, it also adds subjectivity to a process that is already dependent on estimates.
The value theory approach uses an estimate of how much value a product provides to customers and how much of that value the company can capture through prices (see Figure 3). Value theory helps companies focus on what brings the customer value and consider whether they will be able to capture that value. This analysis is commonly used to estimate the TAM for a new product that will be sold to existing customers. Cross-selling is an important consideration for start-up companies because it can help increase their overall growth potential.
Example. Driverless Trucking Co. is attempting to apply its driverless technology to drones that could be used to make small shipments directly to the final customer. Retailers currently pay about $7 in shipping costs per package. DTC estimates the benefits of faster, more efficient delivery to the end customer will add on average an additional $1.50 in value per package. Because of high competition in the package delivery industry, DTC determines that it could capture about $7.50 of this overall value of $8.50. DTC then analyzes its internal data and finds that 20 percent of the 100 million packages that it delivered in the past year could be delivered using drones. Therefore, DTC could expect to have drone shipping sales of approximately $150 million in its current market (100 million packages x 20% x $7.50 per package). DTC would then use a bottom-up approach to project that value to all target markets to find a final TAM.
TAM Analysis Shortcomings
In many aspects, TAM estimation methods are more of an art than a science, and none perfectly calculates the actual size of the market. They ignore potential market increases caused by the actions of a disruptive company and potential market decreases caused by technological advances. Additionally, the company could expand into markets that were not initially considered in the analysis. For example, Uber’s TAM originally included only the taxi industry, but it has since expanded to include food delivery and other forms of transportation. Despite these weaknesses, TAM is still a useful measure for the growth potential of a company and can help the company identify target markets and competitors. When companies make the effort to calculate TAM, it sends a positive signal to investors that they are actively planning for their future.
A TAM analysis helps investors understand the growth potential of their business and the competitive environment of their industry. Additionally, TAM is a key consideration of investors looking for companies with potential for high growth, and therefore a high return on investment. Whether your company uses the top-down, bottom-up, or value theory approach for calculating TAM, you should understand the advantages and disadvantages of each. Ultimately, understanding TAM can help guide your company to a winning strategy.