4 Methods to Calculate the Total Addressable Market (TAM)

date: 2021-06-13 21:11:44

 

One of the most common questions startup founders ask is how to calculate their total addressable market (TAM). But first, we need to understand what TAM actually is. TAM is defined as the entire revenue opportunity that exists within a market for a specific product or service.

 

Additionally, calculating the TAM also assists the company in understanding the product/service evolution during time, it provides an indicator on assessing whether you are on track on achieving product market fit, understanding competition and finally, it indicates to investors that you are performing your due diligence and research accurately.

 

Currently, especially for a company’s stakeholders, the TAM has become a vital metric and as a result of the increase in emergence of new markets, more creative process of calculating the TAM has appeared as a result.

 

An important thing to always keep into consideration is that the TAM, must be as specific as possible. A general high-level figure always results in scepticism from stakeholders and could potentially indicate that the company owner does not show conviction in his/her work.

 

Assuming you could not explicitly find the TAM of your product or service, the following are the methods used in calculating TAM:

  • Top-down approach, 
  • Bottom-up approach, 
  • Value theory, and;
  • External research

 

Top-down approach

This approach begins by taking a high-level view first and then narrowing it into sub-sectors until you reach the figure that is actually specific to your product/service

A quick example, is that your company is operating a company similar to Uber at the early stage, first you would try to get total market size of the transportation sector in the countries you are operating in, then you would need to further narrow down to only the market size of taxis.

 

Bottom-down approach

The bottom-down approach is simply the opposite of the top-down approach. It involves working on finding data of a certain dataset and then computing the wider TAM based on that figure. 

This method is considered one of the most accurate methods (along with the value theory approach) because you are basing your assumptions on an actual data point. These type of data points could be derived from various sources such as surveys, company filings or news reports. 

The disadvantage of this method is that various assumptions are made on top of the data point derived which in turn could materially affect the TAM being calculated and that the whole basis of your calculation is based on the accuracy of the data point derived.

 

Value theory approach

Unlike the aforementioned couple of methods which usually look at existing markets and assume that a new product/service will fit into it, the value theory is usually used when calculating the TAM of a relatively new market.

Using the value theory, you first have to assess the price which an individual/company would pay for your product / service and then understand how many individuals and companies are actually paying for the current comparable product/service being used. An example of this is Netflix, at the time consumers would pay a certain amount to purchase DVDs or purchase movies online, using the value theory we can calculate the TAM by attaching the price that consumers would pay to register on Netflix with the current number of individuals that purchase movies using the current system.

 

External Research

The last method is to simply reference the TAM to research reports or data that was collected from research companies. Various companies perform research reports, like IDC, Forrestor and Gartner. The disadvantage of this method is that if an investor or stakeholder needs to understand the rationale behind that figure, you will not have an adequate answer and will state that it was published by X company.

 

In summary, calculating the TAM is a vital exercise that would shed some light on how large your market is.  A final important note to take into consideration is to always use conservative assumptions in order to avoid overestimating your TAM as well as avoiding having any investor or stakeholder feeling misled or sceptical about the figures being used.

 

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