My unconventional take on using TAMs.

In previous discussions, we’ve touched on the concept of the Total Addressable Market (TAM), its significance, and its application in valuation. I believe it’s important to delve deeper into this topic as the TAM is becoming increasingly crucial for investors. The global landscape is changing, with trade barriers diminishing and businesses adapting to a constantly evolving international environment.

Companies are no longer confined to their domestic markets due to the considerable ease of conducting global business. This is largely driven by technological advancements and increased interconnectedness. This expansion presents businesses with a significantly larger market to explore. This also introduces greater complexity as the potential market seems boundless. I am convinced that understanding and utilising TAM methodologies will remain invaluable to investors.

In addition to the more common approaches to using Total Addressable Market analysis, I outline a few ways I use the concept.

The abuse of Graphs in Reports and Presentations will always exist.

By comprehending market sizes, investors can make more informed decisions when assessing the growth and opportunities of the businesses they are interested in. Among the many “Investor Presentation Crimes,” the misuse of TAM charts and potential market size is the worst. Many companies exaggerate their TAM, claiming it to have enormous potential, as a tactic to attract shareholders. This creates misleading expectations. Shareholders need to keep in mind businesses need to crawl before they walk.

The Huge Opportunity ahead is not about being sceptical all the time when a business presents these wild numbers. It is about verifying, as we’ve touched on before, and understanding all the steps on the way to capturing any meaningful amount of the TAM.

Understanding the practical boundaries of what companies can realistically pursue is beneficial for evaluating potential investments. This helps investors to grasp business limitations, future prospects, and the feasibility of executing ambitious strategies.

🔍 The Total Addressable Market areas of focus…

The Total Addressable Market (TAM) refers to the maximum potential size of the opportunity for a specific product, service, or solution within a given market. This represents the total demand for the product or service if every potential customer adopted it. In other words, it assumes 100% market share.

The TAM is useful for both business management and investors for various reasons outlined below.

Estimating market potential: TAM helps businesses estimate the potential size of the market for their product or service, which is essential for creating a smart business plan and market strategy.

Resource Allocation: TAM helps businesses determine the required effort, resources, and market opportunity for a specific product or service, allowing them to allocate resources effectively.

Competitive analysis: TAM provides a benchmark for competitors, helping businesses understand their market share and potential growth opportunities.

Growth strategy: TAM helps businesses identify areas for growth and expansion, enabling them to develop targeted strategies to capture a larger share of the market.

Investment decisions: TAM is an essential metric for investors, helping them evaluate the potential return on investment (ROI) for a particular business or product.

Used by Management so it should be adopted by Investors.

The initial stage for a new startup or a company expanding into a new division involves the question, “How many clients and customers can we sell to?” From an investor’s perspective, this can be reframed as, “How big could this business potentially be?” Investors and management can both use the Total Addressable Market (TAM) framework to assess opportunities.

Understanding the market potential enables investors to evaluate the business’s requirements for expansion into the market size. If an investor determines that the market potential is substantial, but the resources needed to expand into it require significant cash, strong competition, and a lengthy time horizon, it may lead them to pass on the opportunity.

I have used TAM analysis to evaluate smaller companies and some rare, large companies that are leveraging “Optionality”. For smaller businesses, I have made buy and sell decisions based specifically on TAM analysis.

Companies frequently assess market size and potential to aid in strategic resource allocation for scaling up. For instance, if a company perceives a significant opportunity for global expansion, prudent management may acknowledge that, while the market size is substantial, the cash outflow, working capital demands, and the extended time horizon before returns are achieved could strain the company.

Oftentimes, poor timing of expansion and understanding of the market potential leads to a lot of business failures. Companies need to scale at the right time, with the right resource allocation and a strategic staggered growth plan in place.

The TAM is frequently misunderstood and misused by both investors and business management.

TAMs is more qualitative analysis…

It’s incredibly rare for a company to list its market potential and then strategically, year after year, go after it and actually capture it. Think about Netflix and Amazon in their initial presentations, or even Airbnb. They had listed huge market potential…and they delivered.

For investors to be able to take guidance from management in relation to TAMs, an investor needs to qualify a few areas. Just as the TAM guides the management and teams towards a common goal, investors need to also measure the same metrics of performance.

Investors need a gauge to understand and track how close a business is to capturing a slice of the market share.

Management can easily present Total Addressable Market data, but it needs to be supported with a clear strategy. If a business can’t demonstrate it has a plan to slowly penetrate the market, then it becomes hard for investors to track performance.

The strategy should be understandable. For example, the number of products sold, the amount of customers, or subscribers. Investors need to find the exact metric that management uses to manage KPIs and internal expectations to the team.

What is the #1 Metric to measure performance?

Once you have the most important metric to determine how the business is growing into the market share, we can track this among the industry and other competitors as well.

Management should outline what is required to get to the size they expect to get to. For example, Does the plan require more marketing and sales outlay? What sort of cash will they require for this? What initiatives are management prioritising to support the strategy?

To get a clear picture of the potential market penetration, investors need to understand all the metrics that the business will also use. Sales forecasts, competitor analysis, the risks, etc…

If management do not have clear goals and objectives to take advantage of the available opportunity, then it does not give much confidence to shareholders. This is why I believe TAM analysis is more qualitative than quantitative.

Although numbers are important to estimate future revenue, valuation of the business, and overall financial potential, it’s the nuance of information in between that allows investors to understand the context of the opportunity.

Overconfidence of the Total Addressable Market.

It’s crucial to avoid overconfidence, especially from management and steadfast shareholders, regarding the market potential. Companies often overextend themselves, making it difficult to recover from a failed strategic plan. Failed strategies to capture meaningful market share caused by Overconfidence and overextension can stem from various reasons.

Drawing from my experience in investing and running companies globally, I’ve identified the following as some of the causes:

• Failure to recognise the real market potential and, consequently, a realistic market share.

• Neglecting to study the competition or take them seriously.

• Didn’t have the management or team expertise to pull it off.

• Lack of conservative budgeting, forecasting, and financial resource allocation.

• Failure to understand their own product or service fit and customer adoption.

• Miscalculating the time required to execute the strategy, resulting in increased cash burn.

• Failing to create a plan with “bite-sized chunks” and instead aiming straight for the top.

• Misunderstanding that what works domestically doesn’t always work internationally.

I share these insights to help investors analyse potential companies with the knowledge concerning past failures.

Investors can also overvalue the opportunity based on TAM valuation metrics by being too overconfident in measuring the market size. Never base valuation on phrases like “Let’s just say hypothetically the company captures the whole market share of …”. Be realistic when evaluating opportunities.

Using these questions to answer 3 big questions…

With these questions in hand and the metrics to measure performance, investors can try to piece together the opportunity. When I am using TAM analysis from the qualitative perspective, I am trying to answer these questions:

How big could this thing be?

What is required from the business to pull this off?

What is the likelihood it can pull it off?

Most companies that list huge market potential linger around year after year and don’t deliver or capture any meaningful size of the pie to deliver outsized returns to shareholders.

I say NO to the vast majority of companies that outline a big TAM without a clear strategy to go after it…

With these questions, I set out to address each one with a lot of supporting information. There are a range of areas I will look at, from balance sheet strength, cash in the bank, funding and capital needs, competitor landscape, and the management’s ability to execute the strategy, all with the aim of either supporting the likelihood or revealing its unlikelihood to pull it off.

Simple areas such as understanding the product or service and what options and alternatives exist in the marketplace. Then try to understand how it distinguishes itself or competes with what exists. I’ve found a lot of the time, there are already far superior products and services that are doing great things and will continue to capture the market share. So, I don’t bother to research the company any further.

Trying to evaluate the potential for smaller companies is more art than science.

Most of the time, I use this analysis for micro-cap and small-cap companies, as that is where I predominantly play. So many investors get swept away in the euphoria of story stocks, nice colourful charts showing the potential, that they forget to look at what exists and why this company believes it is better than other companies, as well as why do they believe customers will choose them over alternatives.

By answering the requirements and resources that the business would need, I am able to gauge the likelihood that it can grow any meaningful slice of the market share to make for a viable investment.

This is not analytical; it’s not really backed with numbers and spreadsheets. It leans more on my own experience in running companies and strategically using TAM analysis of the entire landscape to assess whether we were able to expand or even should we expand.

💦 Pay attention to Market Saturation…

When you first start researching a company using the TAM method, market saturation requires attention. Market saturation presents challenges for a business to gain a significant share as it may not be cost-effective to distinguish itself from competitors. This situation can have an impact on both profitability and revenue targets.

For a company to enter a saturated market, the strategy needs to be comprehensive, encompassing marketing and sales, brand strength, innovative ways to capture market share, and competition, all while avoiding a price war.

---

A market is never saturated with a good product, but it is very quickly saturated with a bad one.

Henry Ford

---

The more saturated a market is, the more cautious I become when looking at the market potential. Many factors need to be in place to increase the chances of success. Most companies I research that are entering saturated markets don’t pass my initial test.

The strategy needs to be precise, the innovation spot on, the timing of growth perfect, and financial resources and capital allocation need to be diligently managed. You really must answer the “likelihood” question. Who has tried to do what this business is doing and failed? Finding reasons why others didn’t succeed can help to create strong bear cases and risk profiles to monitor if you choose to go ahead and invest.

I’m certainly not suggesting companies that are entering markets that are not crowded have less stringent research methods. It’s more that companies with great products or services, a good management team, a healthy balance sheet, and a good plan can make a few errors that won’t crush them. For a company to enter a saturated market, a lot of the “Stars” need to align to pull it off.

🌍 Big and Juicy Total Addressable Markets…

I prefer to invest in companies with large Total Addressable Markets (TAM). A small TAM indicates that the business may not have much room to grow in the long run. Ideally, I look for companies with a great product or service, managed by a strong team with a solid balance sheet, operating within a growing market with a huge TAM.

A large TAM means that a company has significant potential for growth, which can lead to an increase in its share price. It’s difficult for a company to grow to $10 billion from a small position if the TAM is only $1 billion.

For long-term investors, finding high-quality small businesses that are gaining market share from a small base and have substantial market potential can lead to significant returns.

It’s the SAM and SOM that count…

Investors need to understand the SAM (Serviceable Obtainable Market) and the SAM (Serviceable Addressable Market) more so than the TAM.

This is the big difference that a lot of investors miss. The total market may be $100 billion, for example, but the products and services fall into a segment of that market, and so that may only be $10 billion.

This dramatically changes the landscape of the business. Investors may think a company has 5% market share of a big total addressable market, but in fact, it has 50% share of the serviceable addressable market already.

Companies that already have captured meaningful market share have minimal room to grow. Unless they are of high quality and have a strong competitive advantage, they may be ripe for disruption as new competitors come in.

Understanding the serviceable addressable market (SAM) and then the portion of that market the company actually addresses is critical. It puts the entire opportunity and business into context.

I refer to SAM as the immediate opportunity and TAM as the big picture opportunity (future optionality).

By understanding the SOM, you can see currently where the business is concerning the size of the market it can realistically go after.

This can narrow down your analysis to the potential of the immediate market size, the competitors that pose the closest threat, and study the trends within that segment, as opposed to an entire market.

In Summary…

It is crucial for investors to consider market sizes as this can provide important insights into the businesses and industries they are investing in. While Total Addressable Market (TAM) methods are commonly used for growth companies, small-caps, startups, and VC firms, they can be applied to analyse businesses of any size.

Investors need to understand the current market share of a business, its competitors, and how consumers or customers are adopting its products and services. This understanding is essential when evaluating potential investments.

There’s no magic formula for using TAMs. A business with excellent products and a large potential market ahead might not be a good opportunity if it’s poorly managed. Similarly, a company with exceptional management and a strong product entering a massive and expanding TAM might not be a good opportunity if it is cash-strapped or has limited resources. Even if a company has abundant resources, a great team, and a large TAM, it might not be a good opportunity if it fails to distinguish its products from competitors.

There are a lot of ingredients that go into the mix when studying, analysing and making decisions based on Total Addressable Market research.

All scenarios involve risks. Venture capital (VC) firms take significant risks, which is why they invest in many companies in the hope that one or two will pay off big time. As private investors, we can’t take these “Calculated Punts.”

The Total Addressable Market presents opportunities for many businesses, but only a few meet the criteria to capture a meaningful size. You should aim for the ones that do.