What Is Total Addressable Market (TAM)?
Total addressable market (TAM), also known as the total available market, means the maximum revenue earned from all potential customers a company can reach for a product/service in a specific market. For instance, if a company sells its ABC product to every prospect across its XYZ target market, the resulting revenue will be its TAM.
However, this kind of market sizing can only provide a holistic assumption of the revenue opportunity. Hence, TAM is generally used to measure the market potential and the kind of resources a SaaS company would require to maximise opportunities for a new product or market.
Why TAM Is Important For SaaS Businesses
TAM is a useful metric that provides comprehensive insights into market entry, customer segmentation, product development and resource allocation. As a result, companies can analyse new markets, adapt to changing market conditions and stay ahead of the competition by continually monitoring and reassessing TAM. Here are three key areas where TAM can help:
Provides a roadmap for business owners: Knowing the market potential helps businesses utilise their time, money and talent wisely. Consequently, founders can focus on what matters most and make sure their efforts match emerging opportunities.
Assesses product-market fit: TAM can lead to a better understanding of product life cycle, evolution and trends. If businesses want to attract more customers or make new product features, knowing the market helps them make smart choices.
Attracts investors: When businesses mull fundraising, they need to show potential investors a sustainable growth plan and well-researched strategies to achieve critical milestones. A look at the TAM helps them explain the road ahead step by step and reveal a realistic valuation in sync with the market.
How To Calculate TAM: A Look At The Four Methodologies
There are several ways to calculate TAM, but most businesses adopt one of the following four methodologies.
Going bottom-up: Think of a SaaS company offering project management software and exclusively catering to small businesses. To calculate the TAM bottom-up, it determines the number of small businesses located in that city and willing to pay for the product. Now, the company has a data subset, a localised and granular view. However, the market potential of the software can be extrapolated from the micro-sample to estimate the TAM for similar cities and then the entire region. But there is a catch. Although the data subset is first-hand and sound, overall data will depend on vast assumptions, and the TAM calculation could be wide of the mark.
How top-down works: In contrast, a top-down approach takes a macro view of the market and segments it later. For instance, the B2B SaaS company mentioned earlier may begin by researching the pan-India demand for project management software. Once it has the broad market data, the company will chip off all irrelevant parameters, such as requirements from enterprises and mid-level businesses and locations/industry segments not covered, to focus on the specific market it serves.
Again, the data may not be too accurate due to various theoretical assumptions. For example, similar cities may not host the kind of small businesses the SaaS company targets, although the demographic and economic details resonate.
Let us consider a simple use case. A SaaS company is developing customer relationship management (CRM) software for real estate agents. Here’s how they estimate their TAM using a top-down approach
Total Real Estate Agents: They start by looking at the total number of real estate agents worldwide, which is approximately 2 Mn.
Identifying Target Market: They determine that not all real estate agents need their specialised CRM software. Their research shows that 40% of real estate agents would benefit from their product.
Specific Market Segment: The company also learns that among the 40% who would benefit, 60% of them are in regions with high property transaction volumes, such as major cities. This means there are 40% x 60% x 2 Mn = 480K potential customers.
Pricing Model: They plan to offer their CRM software at a subscription fee of $50 per month per user.
TAM: To calculate the TAM, they multiply the number of potential customers (480K) by the annual revenue per user, which is $50 x 12 months. This results in a TAM of $288 Mn ($50 x 12 months x 480K users).
The value theory: This approach calculates if a market is willing to pay for an improved or evolved product. Think of driverless cars or passenger drones, which will transform personal transportation in the long run. That’s why forward-thinking companies are conducting surveys and building prototypes for potential customers to understand how much value they place on these products. In this way, they can estimate the TAM more accurately by assessing the value proposition and what the prospects are willing to pay.
Third-party research: Ready-to-use private research reports also provide essential data required for quick and easy TAM calculations. As skilled analysts and industry professionals develop these reports, these documents guarantee data authenticity. However, some businesses are reluctant to rely on these reports due to their no-questions-asked stamp of validity. So, they prefer to gather data independently, believing it will lead to more authentic outcomes.
The Mistakes Founders Make When Calculating TAM
As TAM is primarily assumptive in nature due to its bottom-up and top-down approaches, business owners often encounter common pitfalls like adopting an overly narrow or broad focus not in sync with market realities.
At times, it entails going for a micro view and fixating on small data samples as these are easier to access and analyse. But this can severely limit their growth potential. It is imperative to look at the bigger picture to find more opportunities.
But the other extreme, a thoroughly macro view, can be a misstep for businesses entering a new market or product segment. Some founders try to go overboard to capture growth, which can lead to losing focus, missing important details and ignoring limitations that can hurt in the long run. Striking the right balance is crucial.
Moreover, much like other crucial metrics, TAM should not be considered in isolation. Instead, one should look at more granular layers like SAM (serviceable available market) and SOM (serviceable obtainable market).
While the first indicates the target addressable market a company hopes to serve, the latter is the percentage of SAM that a company can realistically cater to. These layered calculations can provide a more comprehensive understanding of a company’s achievable market potential, which will always be lower than TAM.
Finally, gathering sound data is essential for good decision-making. Without reliable information, founders cannot make informed choices to drive business growth. In essence, they should comprehend the market thoroughly, align their focus judiciously and take measures based on robust data to fortify their success.
How SaaS Businesses Can Grow Total Addressable Market
SaaS companies should focus on two primary strategies to broaden their total addressable market. First, they need to adjust their pricing to optimise TAM. This can be achieved through tiered pricing, where additional features or services can be bundled with more expensive packages.
The other success component is market diversification through horizontal and vertical growth. In the first case, a product initially tailored for a specific industry can be extended to new customers and new markets to generate more revenue. Think of an HR or accounting solution that other companies outside the core sector can easily use. SaaS companies can offer simplified versions of the same at reasonable pricing to expand the customer base across industry segments.
On the other hand, one can choose to expand existing products, add value, or develop new products to ensure a better product-market fit to monetise TAM.