Michael Mauboussin: Total Addressable Market – Methods To Estimate A Company’s Potential Sales

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

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Michael Mauboussin: Methods To Estimate A Company's Potential Sales

  • The ability to calibrate the total addressable market (TAM) is a major part of anticipating value creation. Assessing value creation requires understanding how much a company can invest and the returns those investments will earn.
  • We define TAM as the revenue a company could realize if it had 100 percent share of a market it could serve while creating shareholder value.
  • This report provides a framework for estimating TAM through the process of triangulation using three methods. The first is based on population, product, and conversion. Next we examine a diffusion model, which not only addresses the absolute size of the market but also the rate of adoption. Finally, we discuss the usefulness of appealing to base rates as a reality check for optimistic estimates of TAM and growth rates.
  • Companies can expand their TAMs through business category evolution, hence placing their products or services at the heart of an ecosystem. Done successfully, this allows the company to take advantage of network effects, encourages customers to remain within the ecosystem, and extends a company’s period of competitive advantage.
  • We include a checklist to guide analysis and discussion.

Michael Mauboussin: Total Addressable Market - Executive Summary

The ability to calibrate the total addressable market (TAM) is a major part of anticipating value creation. Since 1960, about one-third of the value of the S&P 500 Index has been attributable to the anticipated payoff from future investment. Assessing value creation requires understanding how much a company can invest and the returns those investments will earn.

We define TAM as the revenue a company could realize if it had 100 percent share of a market it could serve while creating shareholder value. You should recognize up front that TAM is not about how large a firm can grow to be but rather how much it can expand while adding value.

This report provides a framework for estimating TAM through the process of triangulation using three methods. The first is based on population, product, and conversion. Next we examine a diffusion model, which not only addresses the absolute size of the market but also the rate of adoption. Finally, we discuss the usefulness of appealing to base rates as a reality check for optimistic estimates of TAM and growth rates.

Estimating TAM is trickiest when both the market and the technology are new.

The first approach to assess TAM is to estimate the absolute size of the market, which has three parts: estimates of the broad population, the percentage likely to use the good or service, and the revenue potential. An in-depth analysis of the absolute size of the market also requires careful consideration of factors that shape demand and supply.

The workhorse for forecasting the rate of adoption for new products and services is a model developed in the 1960s by a marketing professor named Frank Bass. 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. The model helps calibrate TAM as well as the rate of growth in getting to TAM.

The Bass model relies on three parameters: the coefficient of innovation (p), the coefficient of imitation (q), and an estimate of the number of eventual adopters (m). The primary way to estimate parameters is to use analogies from the diffusion of similar products or services.

In cases where network effects are strong, it is common for one network to become dominant. For most consumer products, the market share of the leading company rarely tops 40 percent, but in businesses with strong network effects, market shares are generally well above 50 percent and commonly closer to 90 percent.

Base rate analysis refers you to what happened to other companies when they were in a situation similar to the one you are examining. No reference class is perfect but the base rate of performance can lend a vital point of view of the plausibility of a TAM estimate. Indeed, research shows that using base rates generally improves the accuracy of forecasts.

Companies can expand their TAMs through business category evolution, hence placing their products or services at the heart of an ecosystem. Done successfully, this allows the company to take advantage of network effects, encourages customers to remain within the ecosystem, and extends a company’s period of competitive advantage.

Michael Mauboussin: Total Addressable Market - Introduction

The ability to calibrate the total addressable market (TAM) is a major part of anticipating value creation. Since 1960, about one-third of the value of the S&P 500 Index has been attributable to the anticipated payoff from future investment. Assessing value creation requires understanding how much a company can invest and the returns those investments will earn.

We define TAM as the revenue a company would realize if it had 100 percent share of a market it could serve while creating shareholder value. TAM is a concept that executives and investors use frequently, but that few define properly or thoughtfully. You should recognize up front that TAM is not about how large a firm can grow to be but rather how much it can expand while adding value.

An exchange in 2014 between Aswath Damodaran and Bill Gurley over the prospects for Uber, the transportation company, brings TAM into sharp focus. Damodaran, a professor of finance at the Stern School of Business at New York University and a recognized expert in valuation, suggested the company was worth about $6 billion, a fraction of the $17 billion value implied by a round of financing the company had completed at that time.2 (A round in the summer of 2015 valued the business in excess of $50 billion.3)

Gurley, a highly successful venture capitalist with Benchmark Capital and an early investor in Uber, responded with an article called “How to Miss By a Mile: An Alternative Look at Uber’s Potential Market Size,” in which he argued that Damodaran’s valuation grossly underestimated the magnitude of Uber’s potential TAM.4 Both men are believers in using discounted cash flow to value the business so the crux of their disagreement, which was refreshingly civil, sat squarely on the perceived size of Uber’s opportunities.

Damodaran calculates Uber’s TAM based on the taxi and car service business, which he estimates to be $100 billion. He then assumes the company can reach a market share of 10 percent, and proceeds to calculate the

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