Total Addressable Market (TAM)

Credit: Credit Suisse

Total Addressable Market (TAM) defined as the revenue the industry will have in the future
There can be many methods of forecasting TAM, here some of them

Market Size: Population, Product, and Conversion

The first approach to assess TAM is to estimate the absolute size of the market, which is simply the number of potential customers times the expected revenue per customer

Three parts are there

  1. An estimate of the population – how many people can use (potential customer) and are using (current customers) the product
  2. Population likely to use that product – there are many products available in the market, which are different in characteristics, price, marketing, etc. (we here need population using our product)
  3. Conversion/ Replacement cycle – how many times the customer is likely to buy that product, what is the conversion cycle of that product

Demand

  1. Sometimes, the user and payer of a product are different people, in these cases, you need to consider the needs of the user as well as the incentives of the payer
  2. Financial resources: How much money do the buyers have? Are their resources growing or shrinking?
  3. Physical limitations of using that particular product
  4. The elasticity of demand, where an increase in price will decrease TAM for elastic goods and will increase TAM for inelastic goods
  5. Substitution and substitution threats – that is how many customers we have today and how much we will have. This is a very important consideration while estimating TAM

Supply

  1. Sometimes, sellers and suppliers are different, for example, most automakers use a network of dealers to sell their cars. So, the TAM for the automakers reflects, at least to some degree, the location and quality of their dealer network.
  2. Ability to supply – company’s ability to supply its product is limited
  3. Whether a company is using price for its profitability
  4. Regulation – changes in regulation can highly affect TAM, as regulation decides or changes a parameter for a company
  5. Incentives
  6. Scale – company’s total TAM can be higher, but the ability to scale decides addressable TAM for the company

TAM and the Bass Model

The Bass model allows for a prediction of the purchasers in a period, say for each year, as well as a total number of purchasers

People are more likely to adopt a product or service if lots of other people are already using it

Bass model take 3 factors into account to forecast TAM

  1. The coefficient of innovation – how much people are excited to use that product
  2. The coefficient of imitation – It’s basically the power of word of mouth or social contagion. You want something because all of your friends have it
  3. An estimate of the number of eventual adopters – A parameter that determines the size of the market – potential customers

The rate of diffusion is speeding up – that means, people are adopting new things faster than before

Limitation of bass model

  1. Replacement cycle – once a consumer buys something once, the next question is how frequently he or she will replace the product – replacement cycle is a very essential component to forecast TAM
  2. Economies of scale – when companies can lower their COGS, by a bargain with their suppliers, it is called economies of scale, but when business expand beyond its local strengths, its return on capital and competitive advantage eroded; there is a high correlation between local market share for retailers, reflecting geographic concentration, and profitability
    One of the concepts of the theory is that companies improve their product or service at a rate that is faster than what the market demands. Eventually, customers get more than they need and are therefore unwilling to pay for additional product enhancements
  3. Network effect – Network effects exist when the value of a good or service increases as more people use that good or service; Companies that win network battles enjoy lower costs as the result of supply-side scale and increase the value to the users as the network grows; after having a specific number of user, the cost of adopting user decreases overtime

Base rate as a reality check

The third method in the triangulation process to estimate TAM is a careful consideration of base rates

The idea is to refer to what happened to other companies when they were in a situation similar to the one you are examining

Base rates provide a check on the output of the first two approaches to estimating TAM.

TAM and Ecosystems

Companies seek to place their products or services at the heart of an ecosystem. Done successfully, this creates three specific benefits. First, it allows the company to take advantage of network effects. Second, it encourages customers to remain within the ecosystem, making the customer economics attractive; Finally, it extends a company’s period of competitive advantage

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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