Total Addressable Market (TAM)

What is the Total Addressable Market?

Total addressable market, or TAM is the entire revenue potential for a good or service in a market or industry. If there are no constraints or limitations, it reflects the highest possible revenue possibility for a good or service inside a particular market.

TAM is a critical metric for start-ups and existing businesses to look at as it provides information regarding the maximum potential within their current market. 

As a result, it enables them to determine whether the business prospect is worthwhile, effectively plan and budget their operations, and even grow their company into unexplored markets.

Though there are various methods for determining TAM, they all entail evaluating the total demand for a good or service by considering variables, including market segmentation, pricing strategies, potential clients, and consumers' willingness to pay. 

Note that other significant metrics, such as the Serviceable Available Market (SAM) and the Serviceable Obtainable Market (SOM), are relevant because this metric is evaluated based on assumptions.

Calculating the Total Addressable Market

There are numerous approaches to calculating the Total Addressable Market (TAM). These methodologies are essential for assessing market potential and giving a clear picture of the entire market size; here are some of them:

Top-down approach

For the top-down approach, the analysis begins with a broader market and then slowly narrows down to the particular business segment in which the company is interested. 

This method often uses external industry reports or market research to identify the total size of the industry and then segment it down into specific subsegments.

With this method, the obvious advantage is convenience and the fact that it is not resource-intensive as these market resources are usually easy to obtain. 

However, it also has a drawback: it lacks precision, as variations between research reports can vary.

For example, suppose the total urban population market is estimated to be $1 billion, and electric scooters are expected to capture 5% of this market. In that case, the TAM using this approach would be $5 million.

Bottom-up approach

Opposingly, the bottom-up approach involves figuring out the TAM from the ground up - by estimating the potential customer base and the Average Revenue per user/customer (ARPU) and multiplying these two figures to come up with the total addressable market.

This method is typically seen as a more detailed approach, and they are especially useful when a company is operating in a niche market. 

However, it can be more time-consuming as it requires more data; if customer data are scarce or unreliable, this method may appear less reliable.

For instance, a smartphone company estimates 100,000 potential users in the country are willing to buy their products, and with an ARPU of $500, the TAM using the bottom-up approach would be $50 million.

Value theory 

Similar to the bottom-up approach, the value theory analysis formula also takes the potential customer base multiplied by the ARPU.

However, there is a twist in the process of identifying the ARPU and the customer base. Companies using the value theory approach identify the estimated value provided to customers through their products or services and determine how many customers are willing to pay for that value. 

It can be subjective because of its emphasis on estimating the economic value of the product or service and applying it to its pricing strategies. It may not be suitable for all types of offerings.

Let’s say a start-up came up with a face mask that can entirely filter the microplastic in the atmosphere; they estimate there are around 500,000 people willing to buy their products at the price of $5 per box. As a result, the TAM using the value theory would be $2.5 million.

There are various interpretations to identify the Total Addressable Market, but choosing the most appropriate approach given the products will help ensure the accuracy of the estimated figure.

Differences among TAM, SAM, and SOM

Since the TAM theoretically covers the entire market size, it is not a complete measure, as was previously mentioned. The abbreviations SAM (Serviceable Addressable Market) and SOM (Serviceable Obtainable Market) stand for particular market measures.

As a result, more indicators are employed to give entrepreneurs a more complete view of their market position and expansion possibilities.

SAM is the portion of the total addressable market that a company can practically target (a subset of TAM). SOM is the portion of the target market share that a company can realistically capture (a further subset of SAM).

These concepts are used together in businesses and marketing strategies to evaluate market opportunities to set sensible goals.

Applications of TAM 

The Total Addressable Market (TAM) has many applications across different business functions and stages of a company’s development. 

Here are some key applications of TAM:

1. Strategic Planning

When a company plans for its future, the Total Addressable Market metric works as a guide that helps them look into their current market to identify any opportunities left to capture market share.

TAM also allows them to look into other relative industries into which they plan to expand their operations. Needless to say, by understanding the total market demand, companies can tailor their product development to cater to the needs of the largest possible customer base.

2. Market Sizing

Because it is expressed in terms of either revenue or units, TAM grants companies the ability to quantify the maximum potential revenue opportunity for their offerings. 

3. Investor Presentations 

Apart from existing businesses, start-ups usually use the Total Addressable Market as a pivotal metric. 

Not only does TAM allow these early-stage companies to analyze the competitiveness within their industry, but it also helps them to showcase the potential market for venture capitalists and private equity firms.

4. Valuation Modeling

Every financial model requires a constructed revenue forecast for the company. 

Although there are many methods to arrive at the projected revenue, it can be forecasted by using the TAM and multiplying it by the company’s market share, as the TAM is often expressed in revenue terms.

However, this approach does not apply to early-stage companies as their market share is much more difficult to estimate due to their limited market size.

Conclusion

The Total Addressable Market (TAM) is a vital metric guiding start-ups and businesses by estimating the maximum revenue opportunity within their market. 

TAM can be calculated through various methods like top-down, bottom-up, and value theory.

TAM should be considered alongside the Serviceable Addressable Market (SAM) and Serviceable Obtainable Market (SOM) for a comprehensive view. SAM factors in strategic considerations, while SOM refines realistic market capture.

These metrics assist in strategic planning, market sizing, investor presentations, and valuation modeling, offering valuable insights at different business stages. Choosing the right approach will ensure accurate estimates and inform sound decision-making.

Researched & Authored by Hoang Anh Minh | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

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