The term “total addressable market” (TAM) may sound complicated, but it’s really not.
It refers to the total market demand for a specific product or service. It basically answers the question, “How much revenue can this product or service generate in a specific market?”
If you are launching a new product or service, it’s important to set your expectations right, so you have a good gauge to determine if your product is doing well.
Despite how important the TAM is, many companies (yes, even the big ones!) tend to miscalculate it or even poorly execute their presentations.
It’s worth noting that unless you’re a monopoly, you’ll be highly unlikely to capture 100% of your TAM. Still, knowing your TAM gives you the ability to have both a benchmark and a good idea of just how big your target market is relative to your market share.
A business’s TAM is also good for investors to know if the owner is chasing big goals, making the business worthy of being invested in.
There are three dominant ways to calculate your TAM, so let’s take a look at them.
The top-down method looks at the industry the product or service is in and uses industry research to come up with the TAM.
Specifically, you’ll be looking at market reports, industry data, and research studies. You’ll want to know which parts of the industry align with your own product’s goals and find out how big those parts are.
The problem with the top-down method is in the process itself: research. Companies usually need to supplement the research with additional analyses like surveys or third-party consultations.
There’s also another problem: investors are not keen on trusting the numbers brought about by the top-down method. The data used in the top-down method is usually provided by the company itself.
This can lead investors to think that the data is self-serving and that the method is not entirely transparent.
Additionally, the top-down method does not address any industry disruption that your product’s entry into the market may cause.
Take a look at Uber and Lyft. Initially, their TAM was only supposed to involve the taxi market, i.e., How many riders can they get from the part of the population that used to ride taxis regularly?
However, when they realized that even non-taxi riders could start using their app to get rides, their TAM increased, but this has become inaccurate because it no longer looks at their TAM from the taxi-riding market alone.
Basically, the top-down method accounted for how big their slice of the pie would be, but it didn’t account for the possibility that the pie itself would be bigger.
Unlike the top-down method, the bottom-up analysis looks at the company’s previous performance. Specifically, it looks at previous sales and pricing data.
Multiply your average sales price by your number of current customers to get your annual contract value (ACV). Then, take the ACV and multiply it by your total number of customers to get your TAM.
TAM = ACV x (total # of customers)
ACV = (# of current customers) x (average sales price)
Let’s say, for example, you sell laptops to tech shops in New York that then sell the laptops to their own customers. If you sell 5,000 laptops per tech shop at $700 per machine, on average, 5,000 x 700 =$3,500,000.00. That’s your ACV.
If you sell to 200 tech shops, then your TAM would be 200 x $3,500,000.00 = $700,000,000.00.
The advantage of the bottom-up analysis is that it looks at raw, tangible data. It also looks at the kind of customers the business can cater to, which can be reasonably justified.
The bottom-up method also forces companies to consider another factor that the top-down method doesn’t: product-market fit. Basically, “How does this product fit into the market, and what numbers could we see once it enters the market?”
This method allows businesses to subdivide their TAM according to geographic area or industry segments to paint a clearer picture of how the product will work in different scenarios.
While the bottom-up method focuses on raw data, the value theory relies more on assumptions and guesswork. Still, it can produce a useful answer.
The value theory answers the question, “How much value can this product/service provide to certain customers, and can I sufficiently capture that value through the price I set?”
The fact that it’s based on value already sets the stage for more intangible methods. This is why it’s mostly used for upgrades to products already in the market and for products or services that are so novel that they will essentially create their own subcategory in a particular market.
If you want to use this method, you’ll have to think hard about what customers define as “valuable,” and from there, ask how much they’re willing to pay for that value.
From there, you’ll want to ask how many customers will find that value for the price you set and choose that product over the available alternatives.
It’s murkier and is based on more supposition, but the value theory has its benefits in certain scenarios.
If you’re using the value theory to convince investors to put money in your business, you’ll have to show that the industry’s market size is big enough to create a comfortable footing for your product. If the industry is too small, then your product might end up being a niche product that can’t earn enough profit to break even.
On the other hand, an industry with a market size that’s too big means that it’s oversaturated, making it less likely for consumers to notice the novelty of your product because of just how many alternatives there already are.
It’s always thrilling to visualize your business gaining traction and getting a six-digit or even a seven-digit valuation in the future. But before you act on your dreams, it’s always important to have a realistic set of expectations.
If you want to do it all online, you can find online TAM calculators or spreadsheets that can give you industry figures and statistics, and if you plug these numbers into your own company data, you can easily calculate your TAM online.
Nearly all of them use one or any of the dominant TAM calculation methods, so make sure your expectations are set before you take any action.