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TODAY’S STORY
30 May
,
2022

A primer on TAM.

In 2014, investor Bill Gurley and NYU professor Aswath Damodaran had a debate over Damodaran’s low estimate of Uber’s valuation.

Damodaran arrived at a low estimate as Uber initially set out to win the taxi and limousine market, which Damodaran believed was a pretty small market. Gurley’s point of view, however, was that the future of transportation will be nothing like the past and Uber was well placed to capture this moving market. In a New York Times article, he said, "...in choosing to use the historical size of the taxi and limousine market, Damodaran is making an implicit assumption that the future will look quite like the past."

And Bill Gurley was right. In Uber's seed pitch deck, the size of the overall taxi market was $4.2 billion. And in just the first quarter of 2022, Uber did gross bookings of $26.4 billion. Talk about expanding the market!

But let's not get too ahead of ourselves here. Let's talk about a startup's Total Addressable Market (TAM) and of what importance arriving at a good TAM estimate is to a startup.

TAM refers to the maximum theoretical revenue potential of a company based on the estimated size of the market it can potentially serve and the revenue it can generate — assuming it has unlimited resources and all eligible customers in a target market are acquired.

Why is getting at a good TAM estimate important for a business?

For multiple reasons:

1. How you enter into the market, the customers you target and the marketing channels you use — essentially your go-to-market strategy — is decided by your knowledge of the total addressable market

2. Many early-stage investors want to see a TAM estimate, not just to see the scale and revenue potential of a startup, but also to evaluate the founders' understanding of the market

3. A good TAM estimate can guide your future product roadmap and TAM expansion strategies, and help you measure product-market fit, supplying the "market" numbers in the equation

4. You can't arrive at a good TAM estimate without studying the existing products and competition in the market

So, even though you might say that TAM is just a rough estimate and clearly flawed, especially in the case of startups like Uber, it is a worthwhile exercise for founders to engage in, just to improve their understanding of their business' potential.

To add more resolution to TAM numbers, there are two more metrics:

Serviceable Addressable Market (SAM) — the realistic revenue opportunity when you factor in target customers, the geography your business will serve in, to begin with, and the specific products you'll be selling under the total addressable market, i.e., the proportion of the total market your product serves in. For example, if you say the pet products market is $5bn globally, and you are currently only selling pet shoes in Tier 1 cities in India, then your SAM might actually be close to $200mn since pet shoes only account for 15% of the revenue of the total pet products market (say) and you're only serving Tier 1 cities in India.

Serviceable Obtainable Market (SOM) — the realistic revenue opportunity after you consider existing competition and what percentage of the market YOU can capture out of that. So, if your SAM is $200mn and you think you can safely capture 10% of that market, your SOM will actually be $20mn.

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In summary, TAM is the absolute largest market size you can potentially capture down the line. SAM is the realistic market size basis your current product offering and geography. And SOM is the current realistic cap on your revenues considering competition: no company captures 100% of its market.

Now, before we move on to how to calculate TAM, here's an interesting caveat I want you to think about:

For products that create entirely new markets, or provide a vastly better experience over existing products, do TAMs matter that much? The market is evolving rapidly, and there is no historical data to base estimates on. Besides, consider the case of Uber where the product itself increased the TAM by 10-20x.

So, what do you do in that case?

"It’s the markets that don’t exist that you create. Like, what was the search market before Google? What was the operating system market before Microsoft? What was the cloud business before Amazon? The thinking of big TAM is so myopic.”

— Peter Fenton

In case of startups in existing markets, calculating TAM is easier and a lot more helpful, because sometimes, you may realise that the target market for your product is so niche and small that it isn't worth going after. And you may realise that there is no meaningful way to expand it either. Medical startups solving for a specific ailment usually come under this category.

How to calculate TAM

There are typically two ways to calculate TAM.

One is the top-down approach which bases estimates off of a Nielsen, McKinsey, or Gartner study.

For example, a McKinsey study might say that the education sector is currently $100bn globally and is expected to grow at a rate of 10% every year.

Now, if you're a business school under that market, your TAM goes down basis the proportion of business schools occupying the education sector + the geography you will be serving in.

Also, if you are an ed-tech business and not a conventional business school, you might say that the market for ed-tech is growing at a faster rate in the education space, so the 10% Y-o-Y growth figure doesn't apply to us. For us, it is maybe 20%.

So, your realistic TAM comes down or grows in line with the assumptions you make basis market trends, behavioural trends, cultural trends, etc.

The other approach is the bottom-up approach where you calculate TAM by starting with the number of customers that would use something and what they would be willing to pay.

This is a more realistic value-driven approach where you're forced to think about the value you're creating for your customers and how much of that value you'll be safely able to capture.

In this approach, you start not with market size estimates, but with current usage patterns. For example, in the case of a business school, you can start with the number of students that appear for CAT, NMAT, XAT, GMAT, etc. every year in the country.

Then you can see the number of students who end up enrolling in business programs every year and the average fees they pay for such business programs.

If you suspend disbelief and assume you're going to cater to every one of those students in the future, then the revenue you will be generating is your high-level TAM number.

Of course, you will then need to calculate your SAM and SOM to arrive at more believable estimates.

And even with SOM, you still have a very rough estimate. While running the business, you might find out many unappetizing truths about consumer behaviour and preferences that might reduce your TAM even further. Or in the optimistic scenario, you might find large pockets of the market whose needs weren't being addressed but can be addressed now.

In any case, an exercise in calculating TAM should leave you with a better understanding of the market, its potential opportunities, and its potential risks.

If that underlying purpose isn't achieved, then any number you come up with is as good as a castle in the air. It is fiction and you might as well sell body warmers in the desert.

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