What is Total Addressable Market (TAM)?
Total Addressable Market (TAM) refers to the maximum size of the opportunity for a particular product or solution. In other words, if every single person who could potentially find value in a product or solution purchased/started using it (i.e. 100% market share), how big would that market be?
TAM is not a measure of actual future customers or revenue as competitors and alternative solutions can address the TAM as well—but it gives stakeholders a sense of how large the total pie is before it gets divvied up among the company, its various competitors, and those potential customers who choose to sit on the sidelines and not use or purchase anything at all.
How do you calculate total addressable market?
The fundamental math equation for calculating TAM is a very simple multiplication problem: Average revenue per user (ARPU) times the total number of potential customers in the target market. ARPU is pretty straightforward and can be adjusted as part of the business planning process, but the second part of the equation is trickier.
TAM = (ARPU * total potential customers in market)
External data sources are often used to calculate the total potential customers, whether that means relying on industry analysts or government statistics. But those sources rarely divide the market up exactly how a particular company views it. So, while these statistics can be a starting point, some additional effort must be made to get to a number that more accurately represents the number of likely customers.
A top-down approach to calculating TAM starts with the total number of people (or businesses, schools, etc.) in the world and then narrows that down based on factors like geography and demographics until reaching the target market. This inverted pyramid-style method requires making a lot of assumptions and heavy reliance on data from third parties who may or may not define things the same way. It also doesn’t account for truly disruptive products that actually change or create markets due to their popularity.
The bottom-up approach, conversely, starts with an ideal target market on a small scale and then blows it out to a total. This could be based on looking at a small sample size of theoretical customers and then extrapolating it, however, it is far more useful when it is based on an initial set of customers (say, from a limited pilot test) and then projecting that out over an entire industry, country, or market. Because the data is generated in house and based on real-world experience vs. educated guesses, it is generally given more credence than top-down estimates.
The value-theory approach is the wild card of Total Addressable Market calculation and is best applied when a truly novel product is creating a new category, and there is, therefore, no real market data to base things on. It begins by asking what a typical buyer would be willing to pay for a product or service based on the additional value it brings. This is then multiplied by the total number of people that would also perceive that value and adopt it in place of existing alternatives.
Why is TAM important?
The Total Addressable Market is the first ingredient in almost every business case and the essential information to consider when pondering any business opportunity. Without a sense of how many people or companies could potentially purchase a product, it can be difficult to validate any subsequent assumptions about revenue, growth, or usage.
When an organization considers building a new product, entering a new vertical market, or even adding a new feature, it is critical to understand the revenue impact of that strategic move. Calculating TAM may reveal that an opportunity isn’t as attractive as initially thought, or it could show an even larger market than originally considered. With this information in hand, companies can make more informed decisions about where to invest their time and money for maximum ROI, even discarding their plans when the TAM is too small.
“I’ve seen hundreds of startup pitch decks in my time at Matrix, and have found total addressable market (TAM) slides to be among the most frequently mis-executed.”
– Jared Sleeper, Matrix Partners
TAM can also be of value when calculating the impact of a new market entrant or pricing change. Understanding how market share may change based on these factors is only truly valuable when the total market opportunity is understood since it extends the consequences of these actions to revenue projections.
When investors or board members are evaluating a company or product’s prospects, TAM is inevitably one of the most important data points they will ask for as it provides a relative value for the opportunity size compared to other investment opportunities they may be considering. The TAM calculation process also forces a company or product to truly define itself and see where it falls within the overall competitive landscape.
While TAM may be calculated for a snapshot in time, it will change. Markets shrink and grow all the time based on demographic changes, business cycles, and technology adoption, so when used as part of a forecast those macroeconomic elements should also be considered and calculations should be revisited regularly.