This guide will look at the concept of total addressable market (or TAM for short). Our focus is on giving business owners a practical understanding of TAM and how it can impact their strategy as well as the valuation range for their business. Here are some key takeaways about total addressable markets:
When investors refer to a business's total addressable market, they are referring to the revenue potential of the company's products and services within the business's current market.
While at face value, this concept seems very academic, there is practical value in understanding it. We'll briefly discuss why this concept is important for business owners to understand.
The value of a total addressable market is normally calculated with a "top-down" metric. Here, we start with the total number of people we determine to be in our TAM and we multiply it by our value metric.
For service businesses, it's common to use "annual contract value" as a value metric. So as an example let's assume that our TAM has 2 million people in it and our annual contract value for our core service is $10,000. This would give us a TAM of $20 Billion (2,000,000 x $10,000).
Investors and acquiring companies take TAM seriously, however just because you have a TAM of $20 billion doesn't mean you are going to make $20 billion.
In this light, commonly when TAM is discussed, it is broken down further. So, not only will we look at the total addressable market, but we'll also look at the "serviceable addressable market" and the "serviceable obtainable market."
These are essentially just different perspectives or frameworks for breaking down a business' target market even further.
So, before we defined TAM as the revenue potential of the company's products and services within the business's current market. If we break this total addressable market down a step further, we get to the "serviceable available market."
When we look at the "serviceable available market" we're trying to see the percentage of our TAM that has the strongest need for our product or service. Essentially, these would be the prospects that we feel we would have the strongest product/market fit with, based on the information we have and the way we intend to position our product or service. A good example to understand this might be "location" If we were a local restaurant we could define our TAM as everyone within a two-hour driving distance of our location. While it's certainly reasonable that people living two hours away may come to our restaurant at some point over the next five years, we could look at our serviceable available market to people who live within 30 minutes of our restaurant.
Moving further in this direction, if we were to break down our TAM down further from "serviceable available market," we would end up with our "serviceable obtainable market." This metric looks at the people we believe we can realistically win as customers from within our "serviceable available market."
Understanding the total addressable market, serviceable available market, and serviceable obtainable market will require that the company do market and industry research.
Often, this research proves tedious, but it is important that business owners take the time to do it for several reasons.