The topic of total addressable market, or TAM, is relevant to any business or startup. Professor Paritosh Sharma from Bada Business explains the relevance of TAM and how it can be estimated. With respect to the investors, understanding the total addressable market is very important because it helps them understand the possible sales volume of the product and what strategies have to be developed with regard to growing the business.
Key Note #1: The Formula for TAM
This value is important for business planning and for securing investments. It indicates the revenue target that a business can realistically achieve based on a clearly defined segment of the market. The calculation of TAM can be done as follows:
TAM = Number of End-User Profiles in the Beachhead Market x Annual Revenue Per User
Let’s simplify this with concise steps:
Step 1. Determine Your Beachhead Market:
Now that you’ve decided on your beachhead market, the next step is to figure out how many potential actual end-users there are in this market. These users are the consumers who will purchase the product or services directly.
Annual Revenue Per Each End-User Calculation:
Now, you should assess how much revenue each of these end-users will generate every year. This could stem from primary research, which is direct feedback from the customers, or secondary data from the market research of analogous products.
Multiply the Two Values:
After you get the amount of end users and the revenue every user brings in, simply multiply the two to find your TAM. This number tells you how big your market is, so you know the approximate revenue you can make if you enter this market.
Key Note #2: Calculation Techniques for TAM
There are two broad subdivisions of TAM understanding and computing:
Bottom Up Research (Primary Research)
You get information directly from the primary or target audience in this method. You dig as deep as going one-on-one or giving out in-depth forms and find out how much a typical customer is most willing to spend on your product. This is more time consuming, but the information and insights garnered will be astoundingly accurate and reliable.
Top-down Analysis (Secondary Research):
With this method, one estimates the size of their market by analyzing the existing data. For instance, you may send out a Google form within your personal network (WhatsApp groups, email lists) and gather responses from prospective users. With this data, you can form a better picture of your potential customers and their buying habits.
Once you have calculated your TAM, the next step is calculating the revenue potential in your beachhead market. Revenue Potential = Annual Revenue Per User x Number of End-Users.
With this calculation, you will estimate how much revenue your business can make, given that you capture the market you defined. This figure demonstrates the most you can grow within this segment.
Key Note #3: Evaluating Business Viability Based on TAM
Your business TAM is one of the top indicators of success for your venture. This is the step where you analyze if your business is subjected to a feasible market opportunity.
TAM Below 5 million: $5 million or lower is an indication that the TAM for your business is too small. Though it may be fine for niche businesses, if you’re looking to scale up, then you will need a larger market.
TAM Between $20 Million – $100 Million:
If you’re looking to grow your business, the lower the TAM, the better. In this case, the market opportunity is huge which will appeal to investors and put the business in a growth-oriented position.
Overestimation of TAM:
For instance, most entrepreneurs exaggerate their estimated target audience market size to get investor attraction by claiming over $1 billion in the first year itself. But such claims are easily recognizable as unrealistic. A $1 billion estimate without clear back market data gives the impression that the entrepreneur has no idea about his market segmentation, end-user profile, or the dynamics of the market. The investor is likely to think they are either trying to oversell or, as the phrase goes, “shoot an arrow in the dark.”
The Importance of Research:
To avoid such scenarios, I suggest failing spending an ample amount of primary research time at the very beginning. Investing 4-6 weeks in this research allows the person with clear understanding of any market that ensures targeting the right customers is possible. Waiting too long and attempting to figure this out after 6 or 12 weeks may incur some nasty consequences such as the product losing relevance, funds depleted, and getting stuck in a negative spiral.
Clear Examples of Businesses that Succeeded Due to Proper Understanding of Their TAM
Having a proper understanding of TAM can make the difference when it comes to starting a new business. The following are examples of established businesses that clearly understood their TAM and succeeded:
Facebook:
When Facebook was originally launched, Mark Zuckerberg did not have his sights set on the entire world. He began with Ivy League colleges and gradually expanded. This understanding of his TAM helped Facebook scale and ended up becoming the platform it is today.
Quora:
Quora started as an invite only web based social network intended for intellectuals, thinkers, and content creators. By allowing only a small subset of users, the platform ensured that it was catering to a group of users who were much more engaged. This was possible because the founders understood their TAM and audience right from the beginning.
Conclusion
In the quest to build a successful startup or scale a business, understanding your total addressable market (TAM) is key. When you estimate your TAM, you estimate the profits you can make from your business, which aids to strategize and makes it easier to pitch the company’s growth to potential investors.
Important parts that you must consider while calculating TAM are:
Market Segmentation
Beachhead Market
End-User Profile
TAM Calculation
Getting into primary or secondary research without knowing what your TAM is poses a significant risk to your business’s growth potential. If you understand your market early on while also keeping your projections within reason, then you set yourself up for success for many years to come.
