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Total addressable market and not losing the forest for the trees
08
Feb
Total addressable market and not losing the forest for the trees

Total Addressable Market (TAM) is a concept used by management and investors to define the maximum market opportunity that is available to a business or a company. TAM analysis is most often used as part of a top-down analysis of market share but is equally useful to bottom-up value investors as a sense check for their assumptions, especially over a longer-term forecast horizon. One of the core challenges of investing is that forecasts of the future tend to deviate from reality (to a greater or lesser extent, for that is the nature of risk) yet TAM analysis can help ground a forecast by establishing the boundaries of reasonableness.

Unless investors have a quantifiable, replicable edge in forecasting the future, they should stick to as few assumptions as necessary to value a given investment opportunity (but no fewer) to minimise the risk of compounding forecasting errors. However, current and future TAM is something that investors should always try to forecast where appropriate, even if said forecast may appear difficult or unreliable. The act of forecasting in and of itself can at times be as insightful as the forecast itself.

Forecasting an addressable market opportunity need not be complicated nor overly scientific. Oftentimes, investors are not analysing companies that are pioneering entirely new industries. Even fast-growing tech disruptors that appear to be upending entire industries seldom forge new ground. In fact, TAM analysis is an especially important sense check to employ when forecasting the growth of rapidly-growing businesses, as the effect of compounding high growth rates over a long time horizon can lead to outlandish forecasts.

Facebook and other social media companies have created services and platforms without precedent and (most) continue to grow revenue at double-digit rates, yet their ad-driven business models tie their addressable opportunity to the total advertising market, which depending on the country is growing at a much slower single-digit pace. Amazon effectively pioneered e-commerce in the US and has grown at double-digits for decades, yet its main addressable market in the US is total retail sales of $5 trillion growing at 3% per annum. Total advertising or retail sales growth is much more straightforward to forecast as they are mature industries, and form the upper bound of reasonableness for company-specific forecasts. Instead of wasting time agonising over revenue forecasts for a specific company in a vacuum, a quick estimate of the future TAM can lay the issue to rest. That is to say, if your Facebook advertising revenue or Amazon retail GMV forecast in 2030 implies unrealistically high market share or indeed exceeds the TAM altogether, your growth assumptions are probably too aggressive.

The other benefit of performing TAM analysis, especially when investing in multiple companies within the same industry, is ensuring the forecasts are compatible across the companies. For example, if you are invested in both Facebook and Google on the basis they achieve certain forecast advertising revenue profiles over time yet these forecasts together sum to more than the advertising TAM, then it is unlikely that both investments will unfold according to your hypotheses.

There are of course challenges to estimating TAMs. For instance, take Amazon Web Services, Amazon’s even-faster growing cloud business. Cloud computing is a truly new industry that is still in its growth phase, and it is difficult to define the existing TAM let alone forecast what it might grow to in five or ten years’ time. This is especially the case if there is one dominant business responsible for the lion’s share of incremental industry growth, such that the TAM grows because the business grows, rather than the business occupying a subset of the TAM. An unduly conservative TAM estimate may result in missed investment opportunities.

A similar challenge arises when a company can consistently expand the number of markets its products and services can address. A case in point is Adobe, which on one hand consistently expanded the use cases of its Marketing Cloud service and thus expanded its addressable markets, and on the other hand benefited from the secular increase in creatives and creators (driven by the internet and social media) that greatly expanded the addressable market for its Creative Cloud software beyond its initially-intended audience.

But the most prominent danger of TAM analysis is overestimating the addressable market, either by forecasting faster market growth than is actually achieved, or by defining a wider market than the company or business can realistically address. If bottom-up company-specific forecasts are sense checked against an overstated TAM, it can create a false sense of comfort or margin of safety and lead to overvaluing an investment opportunity.

Nonetheless, despite its several shortcomings, TAM analysis is a useful tool for investors to have in their arsenal. Because bottom-up fundamental investors spend so much time down in the weeds so to speak, it is easy to become too myopic and lose sight of the forest for the trees. Stepping back and contemplating the total market opportunity available to a company is a quick way for investors to see the bigger picture and check whether their forecasts of the future are grounding in reality today.

Montaka owns shares in Facebook (Nasdaq: FB) and Alphabet (Nasdaq: GOOG)

DH5_2155Daniel Wu is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 8046 5000

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