Pauline E. Ranger Sizing exercises to determine the total addressable market (TAM) have become very popular in evaluating the potential of an enterprise. The TAM is often miscalculated or misinterpreted. This article will explain how to calculate SAM, SOM, and their derivative subsets. WeWork will be used as an example.
TAM is a popular metric that’s often misunderstood
Total Addressable Market (TAM, sometimes referred to as total Available Market) allows a company to determine the overall revenue potential of its product or services. This exercise will help determine the amount of funding and effort to put into a brand-new business. It also provides guidelines on the size of the potential market.
The increased pace of new market development has led to a more creative way of calculating TAM. The realization of Moore’s Law shortens technological improvement cycles and adds (exciting) uncertainties about the rapid consolidation of markets. To do this, entrepreneurs need to have a good understanding of TAM in order to see the blurred boundaries between their calls.
The Benefits of a Thorough Understanding of TAM
It is important to know the revenue potential, but there are also secondary benefits.
Owners are focused on the future roadmap of their product and its evolution.
This tool provides a way to assess the product’s market fit.
Show accuracy and conviction to attract and appease investors.
Early on, put competitors in your line of vision.
In 2014, there was a discussion between NYU Professor Aswath Damian and Investor Bill Gurley about a valuation the former assigned to the latter’s Uber investment. Gurley’s low valuation was a result of Damodaran calculating TAM based on the assumption that Uber is just a taxi/limo company. Gurley responded that Uber addressed a much larger field; it was a transport business.
Damodaran implicitly assumes that the future of the taxi market and limousine industry will be similar to the past by choosing the historical size.
Uber is a good example of the ambition many companies today have to take on a new market. Uber’s initial offer and MVP were initially cabs within the context of people logistics. This was a subset of transportation services. Gurley’s hypothesis has been validated by the subsequent launch of X and POOL services, as well as EATS and RUSH. Uber’s research into self-driving cars and long-distance hauling demonstrates that the company does not plan to stop growing. Uber has no plans to enter the air transportation/freight industry and is not trying to take on its entire TAM.
TAM is the total market size that would be possible for a given product, assuming the provider had unlimited resources and unrestricted access. This is only possible in monopolistic industries where one company has the scale and resources to service the entire market. Generally speaking, only government services and utilities are eligible for this bonus.
Why is it that almost all pitch decks include a TAM if it’s nearly impossible to capture the full value of it? A TAM will generate a lot of numbers, which is attractive and can stimulate conversation. The devil will be found in the serviceable accessible market (SOM) and layers of analysis. It is the last measure that is important, as it shows what can be realistically targeted by the business. Finding the tip of the Iceberg is the key.
In pitch decks, it is common to leave out SAM and SOM in favor of a TAM. This omission can lead to broad and vague generalizations, such as, “We target millennial smartphone users.”
Working Example
For the purpose of applying this article, I’ll go through an example of TAM, SAM, and SOM for WeWork. It is not only a well-known and highly valued company but also one that transcends the traditional perceptions about its market.
Note I have excluded the WeLive(residential living) division due to the complexity of explaining two methodologies for different offerings at the same time.
Calculating TAM
We ask ourselves, “What exactly is TAM?” The total addressable market can be defined as the expected annual sales in a market. Calculating the total addressable market is easy:
Average revenue * Number of customers for all segments of the targeted market
There are three primary methods of collection and one secondary method to calculate TAM.
Top-down is a macro-view of factors at the top of an economic system.
Bottom-up examines a subset from a localized scenario and extrapolates its results to a wider market opportunity.
Value Theory is a theory that focuses on positive externalities derived by an offering in comparison to incumbent options.
This method relies on verified third-party research, also known as outside research. I will explain this first.
External Research
Referencing professional data already collected is a quick and easy way to find a TAM. Press releases can sometimes release the headline figures from private research reports. These figures are useful for a number of reasons. They are easy to obtain, and they have been compiled by an expert professional who has credibility.
Gartner and Forrester are among the companies that research and publish reports on industry sectors. These reports usually contain statistics, such as revenue potential and prospects. Gartner released a press release in 2016 stating the value of the cybersecurity market at 81.6 billion.
This method has the disadvantage that it’s a “black box” in terms of how it was calculated. You can only say, “Well it was published by X so it must be valid” if an investor asks for the reasoning behind the figures.
Top Down Approach
Top-down is based on the idea that you should start from the top of a large data set and then work your way down to find the subsets. Start with a population, then apply logical demographic, geographic, and economic assumptions to eliminate irrelevant segments.
This method has the advantage that macroeconomic data can be found openly and accurately. Cite some sources: UN, OECD, World Bank, and CIA World Factbook.
If the recommended daily intake of water is just 1.9 liters, there are approximately 7.5 billion people on the planet. The TAM for bottled drinking water would be based on an average price of $0.22 per gallon (or $0.32 per liter) and a desired profit margin of 20%.
Bottom-Up Approach
This method is based on working at a very granular level in order to extrapolate to a larger population. It is more accurate because it is built on a data point that has been proven. This can then be magnified in order to reveal the entire TAM population. You can either use primary data collection (such as a market survey) or secondary data (news reports, company filings).
As an example, Tesco holds a 27.8% share of the UK grocery market. Tesco’s latest results show it generated revenue of PS35.9bn (excluding sales of gas and the Republic of Ireland) for the period ending April 2017. These two figures together show that the UK grocery market in 2017 had a TAM (total annual sales) of PS129.1billion ($167.1billion).
The bottom-up approach has the disadvantage that the TAM may be inaccurate due to assumptions made by a small group of people. This is especially true for global TAM calculations, as factors like population density, economic progress, and consumer preferences can vary greatly across nations.
