• Gary Rollo says lean, agile small companies are the engine room of the nation’s innovation here's why.

Addressing the total addressable market

05082019_TAM

Addressing the total addressable market

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.

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.

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 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 cent 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.

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 several digital advertising companies but your revenue forecasts together sum to more than the advertising TAM, then it is unlikely that all the investments will unfold according to your hypotheses.

There are of course challenges to estimating TAMs. For a truly new or revolutionary industry, or a company that can consistently expand the markets it can address, it may be difficult to define the present TAM let alone forecast what future TAM may be. Too-conservative a forecast may cause investors to miss an investment opportunity, while too-optimistic forecasts can lead to a false margin of safety and a permanent loss of capital.

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 grounded in reality today.

If you are interested in learning more on this subject, see this Corporate Finance Institute article.

INVEST WITH MONTGOMERY

Daniel Wu is a Research Analyst at MGIM. Prior to joining MGIM in June 2016, Daniel was an analyst in the investment banking divisions of UBS and Goldman Sachs, where he covered the Infrastructure, Utilities, Technology and Media sectors.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

Why every investor should read Roger’s book VALUE.ABLE

NOW FOR JUST $49.95

find out more

SUBSCRIBERS RECEIVE 20% OFF WHEN THEY SIGN UP


2 Comments

Post your comments