What is Total Addressable Market?
Total addressable market (TAM) is a theoretical revenue figure derived from calculating the universe of potential users for a prospective product or service.
Determining TAM is vital for a would-be startup. Before launching a company to provide a particular product or service, you need to calculate whether there are sufficient prospective customers who are willing to pay a high enough price to make your proposed company viable. This data is vital for everything from developing pricing and marketing strategies to securing financing. Simply put, prospective investors need an idea of how many potential customers there are for your proposed product or service in order to estimate the potential return on any money they put into your company.
The key word in the TAM acronym is addressable. Even if everybody in the world theoretically could use your product or service, you need to objectively determine how many likely would use it. So, when you estimate your potential slice of the pie, make sure you’re not starting with a pie in the sky. Overly optimistic projections that won’t stand up to even the slightest scrutiny scare investors off. “If it’s one to five percent of the pie,” Tx Zhuo of Karlin Ventures noted in Forbes, “you have a realistic plan.”
How Do You Calculate Total Addressable Market?
Most entrepreneurs determine TAM using one of three methods: top-down, bottom-up or value theory. Let’s look at each.
1. Top-Down Analysis
With this approach, you cite a credible source to estimate the total size of the market you want to reach and then project the percentage of that market you expect to reach. Entrepreneurs often favor top-down analysis because it doesn’t take much time or effort to execute. But although a top-down analysis lends a superficial credibility to an investor pitch, any unrealistic underlying assumptions are easy to expose.
We can illustrate the limitations of top-down analysis by hypothetically pitching a random idea for a new business: manufacturing and selling high-end “boutique” shampoo priced at $50 for an eight-ounce bottle. In our investor pitch, we cite a Statistica study that places the annual U.S. shampoo market at $3.14 billion. Then, to make our TAM analysis sound reasonable, we use the low end of Zhuo’s “slice of the pie” guideline: 1% of the total market. We conclude that there is a $31.4 million potential market for our boutique shampoo.
It’s easy to see why prospective investors would scoff. Our top-down TAM analysis is based on an absurdly optimistic assumption that 628,000 Americans would each be willing to pay $50 for an eight-ounce bottle of shampoo. That’s why many investors steer clear of this form of TAM analysis. Too often, the slightest scrutiny sends an entrepreneur’s top-down assumptions right down the drain.
2. Bottom-Up Analysis
As the name suggests, this takes the opposite approach of the top-down TAM analysis. You start by examining pragmatic considerations such as total unit sales (as opposed to the total sales of all products across an entire broad industry) and specific pricing structures, along with unit costs, and then project a potential market for an alternative based on a reasonable presumption of a product-market fit.
So, in the case of boutique shampoo, a bottom-up TAM would look at amount spent on high-end shampoo each year, not just the overall amount spent on shampoo, as well as the cost of manufacturing each bottle of shampoo, the price range of various shampoos and factors such as geographic distribution and online sales vs. in-store sales to determine whether there would be enough of a product-market fit to make a high-end shampoo viable. A bottom-up analysis would certainly reveal that product-market fit would be practically nonexistent in this case.
But for a company that already manufactures and sells shampoo, a higher-end product line — although maybe not as high a $50 per bottle — might well be worth investigating, particularly if the new shampoo afforded a benefit beyond the vague “boutique” designation, such as producing healthier, shinier hair. So, although TAM analysis is usually associated with startups, it’s important to remember that it’s a vital tool for mature companies as well. When you have an existing manufacturing, sales and distribution infrastructure, bottom-up analysis can be an important tool for growing your business.
3. Value Theory Analysis
This is the most calculated form of TAM analysis. It’s an effort to directly answer the two questions foremost in many prospective investors’ minds when they deal with entrepreneurs: What will make your product or service a better value than your competitors’? And is that difference significant enough to entice those who are using the competitors’ products or services to switch to yours?
That second question is as important as the first. And it illustrates why it’s often easier to find investors for companies that offer services rather than products — particularly in the B2B space where services such as information security are vital.
Here’s why: It’s usually easier and more cost-effective for a prospective customer to switch service providers than it is to replace a product that they’ve already purchased.
Uber is frequently cited as an example of a service-oriented startup that grew largely as a result of finding an exploitable niche through a solid value theory analysis. Uber’s ride service is cheaper than conventional taxis. It’s more convenient than public transportation. It’s faster than walking or bicycling. In urban areas it can even offer an appealing alternative to car owners who don’t want to pay exorbitant parking fees or who wish to have a drink or two while out socializing without having to get behind the wheel on the way home.
Uber’s value proposition, in short, is obvious and compelling, and its total addressable market is essentially anyone who needs transportation, particularly in urban areas.
Now compare the challenge of selling transportation, as Uber does, to the challenge of selling a car. A startup that offered a new type of automobile would not only have to convince prospective buyers that the new car is a better value than their existing car but they would also have to convince those buyers that the difference is significant enough for them to replace their existing car. Considering that the average American waits 6.5 years between car purchases, you can see why a startup would have a much harder time selling prospective investors on its value proposition than Uber would.
TAM: The Final Analysis
The bottom line is that if you learn to conduct an effective TAM analysis, you will have a huge advantage over competitors who continue to rely on fuzzy math — which is a surprisingly large number. “One would think we would be better at conducting ‘size of prize’ analyses,” Eddie Yoon and Linda Deeken wrote in their Harvard Business Review article, “Why It’s So Hard to Predict the Size of New Markets.” “But we’re not.”