The overall revenue opportunity for a product or service, given a 100% market share
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Total Addressable Market (TAM), also referred to as total available market, is the overall revenue opportunity that is available for a product or service if 100% market share is achieved. Because it represents the potential opportunity, it is often used to determine the level of funding or resources that a company should invest into a new product or business line.
The concept of total addressable market is important for both startups and existing businesses because it allows them to prioritize specific products, customer segments, and business opportunities, taking into consideration the required resources and potential revenue impact.
Evaluating if a business opportunity is viable involves estimating the market size, overall investment needed, competitive landscape, unique differentiators, and expected growth rate. For example, when a private equity firm intends to acquire a company, it can use TAM to estimate the revenue generation potential of a product or service offered by that company in order to determine if the company is likely to produce a return on investment.
TAM estimations can take untapped markets, products and customer segments into consideration. The assessment helps to determine the actual size of the available market.
Calculating the Total Addressable Market
There are three methods used to calculate the total addressable market. They include:
#1 Top Down
The top-down analysis follows a process of elimination that starts by taking a large population of a known size that comprises the target market and using it to narrow down to a specific market segment. Top-down analysis can be represented by an inverted pyramid that shows the large population of a known segment at the top and the narrowed-down segment at the bottom. The method uses industry research and reports to gather population data.
An example is a start-up technology company that offers an accounting software app targeting small businesses. The company uses on industry research that shows that there are 1 billion businesses worldwide, out of which 30% lack access to premium accounting software (30% x 1 billion customers = 300,000,000 potential customers).
Research shows that 90% of businesses that do not use a premium accounting application employ an in-house full-time accountant. This brings the number of potential businesses to 10% x 300,000,000= 30,000,000. If the business offers a free version of the application and a premium version of the application for a $100 per year annual subscription, the estimated total addressable market is $3 billion (30,000,000 x $100). (All the figures used are based on assumptions as an example only).
#2 Bottom Up
A bottom-up analysis is a reliable method because it relies on primary market research to calculate the TAM estimates. It typically uses existing data about current pricing and usage of a product. For example, for a startup company with a free accounting mobile app and annual subscription option for $100, the business can take a reasonable estimate of the number of businesses in its target market to obtain the TAM.
The advantage of using a bottom-up approach is that the company can explain why it selected certain customer segments and left out others. The company relies on data from its own research or survey and, therefore, the addressable market would be more relevant and accurate rather than when relying on third-party data.
#3 Value Theory
Value theory relies on estimating the value provided to customers by the product and how much of that value can be reflected in product pricing. A company estimates how much value it can add and why it should capture this value through pricing. Value theory is used to calculate TAM when a company is introducing new products into the market or cross-selling certain products to existing customers.
As an example, the value theory approach can be used to estimate the ride-share company Uber’s addressable value. Users opting to use Uber choose between Uber, walking, driving themselves, using public transportation, or taking a competitor’s service. Since users are willing to forego all these alternatives and use Uber, the company can estimate the value that these users derive from using Uber and determine how to capture the value in its pricing.
Differences Between TAM, SAM, and SOM
TAM is an acronym for Total Addressable Market
SAM is an acronym for Serviceable Available Market
SOM is an acronym for Serviceable Obtainable Market
TAM, SAM, and SOM represent various subsets of a market.
TAM refers to the total potential market for a product or service that is calculated in estimated annual revenue.
SAM stands for Serviceable Available Market, and it is the target addressable market that is served by a company’s products or services.
SOM is an acronym for Serviceable Obtainable Market, which is the percentage of SAM that can be realistically achieved.
Identifying these subsets within an industry requires some market research to understand the proportions of each area.
An example is consumer expenditure on food in the UK. In 2014, the value of this market was estimated to be 200 billion euros, which represents the total addressable market. The consumer food market entails fresh food, in addition to alcoholic and non-alcoholic drinks.
The alcoholic drinks industry, which served 49 billion euros, is the serviceable available market (SAM). The industry contains several large manufacturers and suppliers who service the market. A section of the alcoholic drinks industry that is served by one manufacturer is the serviceable obtainable market (SOM).
Importance of TAM
The Total Addressable Market is one of the essential metrics that companies use to estimate the potential scale of the market in terms of total potential sales and revenues. When a company is considering releasing a new product, reaching a new customer segment, or cross-sell an existing product to existing customers, TAM helps show the potential outcome and returns on the endeavor.
Applications in Financial Modeling & Valuation
Financial modeling requires building a forecast for a company, which is dependent on the company’s total addressable market. When developing or analyzing a forecast in a valuation model, it’s important to perform a “sanity check” against the size of the market. Detailed operating models will typically include a build-up from market size to addressable market, to customers, and finally to revenue.
Learn more about calculating the market size and market share of Amazon, Inc. in different global market segments such as e-commerce, advertising, and cloud computing by taking CFI’s Advanced Financial Modeling & Valuation Course today!
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