A Guide to Calculating Your Total Addressable Market
A recent Barron’s article declared the acronym TAM, which stands for Total Addressable Market, the new buzzword of the business realm. Editor, Jack Hough said, “Over the past decade, the compound annual growth rate of earnings calls with one or more mentions of TAM is 17%. That compares with a 14% annual return for the S&P 1500 over the same period. That’s right: TAM is beating the market.” Although the story makes light of how often TAM is being dropped into earnings calls and water cooler conversations, the reason TAM is experiencing a surge in mentions is because knowing your TAM helps sales people, marketers, investors and executives gain a fresh perspective on the market potential of a particular product or service.
What Is a Total Addressable Market?
TAM is a financial modeling term that refers to every person in the market for a particular product (or service). Your TAM not only captures the total market demand for your product (who’s buying), it also defines the total available opportunity (sales potential) your product has. Although it is typically measured in revenue using the Bottom-Up method, it can also be defined as the total population of potential customers your product has by using the Top-Down method. In short, your TAM reveals the highest level of revenue (or highest number of customers) your business can reach when selling your products in a specific market.
What are the Benefits of Knowing My TAM?
- Project Next Year’s Revenue Growth — When you know the number of potential customers you have, you are better able to estimate what your earnings will be. You are also able to accomplish a number of other mission-critical tasks, including: budgeting expenses; planning for new hires; developing market strategies; and scheduling production, just to name a few.
- Eliminate Unprofitable Customers and Markets — While it’s tempting to go after every person in a market, it’s not always wise. HubSpot writer, Clifford Chi, says that MIT’s Global Startup Program uses TAM calculations to determine whether or not it’s worth entering a specific market. MIT’s rule for start-ups is: “an industry with a market size ranging from $20 million to $100 million per year is worth entering. However, if the industry’s market size is under $5 million per year or over $1 billion per year, it’s probably not,” said Chi.
- Set Realistic Goals — Your TAM empowers you to focus on the areas in which your sales and marketing teams have the greatest opportunity by narrowing the environment or territories in which they operate. When you use your TAM to set boundaries for your teams, it enables them to set and achieve goals. It also empowers them to make the most of their time and resources by pursuing the best opportunities and bypassing the leads that will likely be fruitless.
- Establish Parameters for Go-To-Market Strategies – Companies that consistently outperform their competitors focus their efforts on reaching specific niches within their TAM. Once success has been obtained in mastering a niche, it’s time to expand your market and add more niches within your TAM. Ultimately, you will want to repeat this process until total market domination has been achieved.
- Secure Potential Investors — Estimating the size of your TAM enables investors to see the financial opportunity of your products as well as your company’s potential value. “A TAM slide’s role in a pitch deck is to convince investors that the company is chasing an opportunity big enough to achieve venture-scale returns with the right execution,” said Jared Sleeper, Investor at Matrix Partners.
How Can I Calculate My TAM?
There is a simple formula for calculating your TAM: TAM = (annual contract value) x (# of possible accounts). However, you will want to invest some time, energy and research beforehand in determining those values to ensure you plug in the right numbers. We recommend taking the following three steps before calculating your TAM:
Step 1: Ask Questions
Justin Withers, Vice President of Product Marketing for B2B data firm, DiscoverOrg, recommends asking and answering the following questions before calculating your TAM:
- What are the characteristics of our current and potential customers?
- What industries are we likely to sell to?
- Where are those companies located?
- What is the average size of companies buying our solutions?
- How is the market growing? Are there new entrants? Bigger budgets?
- Where is growth expected?
Step 2: Do Your Homework
Before calculating your TAM, it’s a good idea to either invest in or perform your own market research. Alon Amar, an analyst for the investment firm Viola, maintains that the goal of pre-TAM research is to have a clearly defined market segment and customer profile, and an understanding of both the intended buyers and users of a product. “In order to approximate TAM accurately, the market should be examined in as much detail as possible, because the less specific the inputs used for the calculation, the less meaningful the resulting calculations will be,” said Amar.
Step Three: Choose Your Calculation Method
The two methods used most often to calculate a TAM are the Top-Down method and the Bottom-Up method. To help you select the right method for your purposes, we will explore the pros and cons of each, below.
Calculating TAM Using the Top-Down Method
The Top-Down method is a big-picture and generalized approach that uses industry research to determine the size of your TAM. Companies that use this approach are typically basing their assumptions off of research firms, like Gartner or Forrester. Sleeper maintains that while the Top-Down approach is a good starting place, it has several shortcomings, including:
- It relies on the expertise of others and uses information that it is already collected, so it is not actually specific to your TAM.
- If a product is disruptive, it has the potential to change a TAM significantly, which makes industry-derived TAM numbers irrelevant.
- A superior product can dramatically increase the TAM for an entire industry.
Research Analyst, Amanda Uyesugi, agrees with Sleeper’s estimation of the Top-Down approach, stating, “Leveraging research that has already been conducted is the easiest and fastest approach and is fine for high level estimates, but it is generally not very actionable and carries a lot of uncertainty.”
The Top-Down Method in Three Steps
A Top-Down approach is typically represented by a three-step upside-down pyramid. Amar recommends thinking of the Top-Down method as a process of elimination in which the decreasing population at each level of the pyramid represents a step in the elimination process.
- Define the Macro Economy — Identify a large population of a known size that encompasses your target market.
- Define Market Segment — Narrow down the number from the larger population to focus on a specific market segment.
- Define Addressability — Isolate the number of potential customers of the selected market segment.
Example: Let’s say you sell software to colleges in America. The total population of colleges in the US (Macro Economy) is 5,300. The software product for which you want to calculate a TAM is an engineering tool. There are 519 colleges in the US with an engineering program (Market Segment). Last year, your company sold 20 licenses (Market Penetration) and so your TAM is 499 US colleges.
Calculating TAM Using the Bottom-Up Method
Viewed as a more precise and accurate way to calculate a TAM, the Bottom-Up method uses your company’s actual data, instead of general market research, to determine market segments. The Bottom-Up method is typically represented by a three-step pyramid that includes the following steps from bottom to top:
- Mine Company Product and Market Data – Gather all pertinent information and data regarding the history of the product you want to sell and the market niches you are currently selling it in.
- Explore Market Segments — Leverage both competitor and your own product performance data to determine the types of customers your product has the ability to win over.
- Determine Addressability of Each Segment — Identify the number of potential customers within each segment.
Example: Let’s say our engineering software from the previous example is designed to be used by chemical and biomedical engineers. Our product performance data reveals that last year, we sold licenses to 20 colleges for $50K per year (Annual Contract Value). Our market data reveals that half of the licenses sold were used by the chemical engineering departments. The other half of the licenses were used by biomedical departments. Of the 500 remaining colleges, 150 offer chemical engineering degrees and 75 offer biomedical engineering degrees. Our TAM for the chemical engineering segment is: 150 X 50,000 = $7,500,000 and our TAM for the biomedical engineering segment is: $3,750,000.
The Power of the TAM
Based on the previous example, it’s easy to see how knowing your TAM can help determine how your marketing dollars and sales team efforts might be allocated in different ways according to specific goals. Of course, if you have questions about how you can best view your data so you can calculate a more accurate TAM, Sureshot can help. Feel free to contact us anytime to talk TAM.