OBSERVATIONS AND INSIGHTS




2021-10-25

ESTIMATING MARKET SIZE

Estimating the size of a market is crucial for investment decisions, strategy definition and valuations.


Knowledge and estimation of a company's market, actual and potential future, is fundamental for both strategy and valuations. Deciding to invest in a new product or business depends not only on the number of customers served today, but also on realistic estimates for the future. However, this all assumes that the "customer" is well-defined, part of a larger accessible market, and last but not least, that the company's strategy can efficiently target and cater to the customers.


So how do you estimate market size? There are several ways of estimating the size of a market, and I stress "estimate" because that is what it is at the end of the day - a qualified guess based on a certain set of assumptions. A good estimate builds on high-quality facts, conservative assumptions, and transparency - as opposed to debatable and ambiguous figures and guesses.

Knowing your customers and customer segments.


First of all, have a clear understanding of who your customers are. What characterizes them, what are some of their common traits? Can they be grouped or classified into segments? Are the differences between one segment compared to another sufficiently clear and logical?


Gaining a clear idea of who a company's customers are and the grouping of these into segments is a big step to start collecting the data, facts and deciding on which assumptions to rely on for your market size estimation and ultimately how much of the market you believe your business could capture.

Bottom-up vs Top-down approach


In general there are two common approaches when estimating the size of a market: Bottom-up and Top-down. While each approach the challenge from opposite angles, each serves its specific function to highlight certain aspects and opportunities of a market. In best cases, both are relied upon to support the decision-making of investing in a new product, feature or business.


Top-down generally looks at a market from a total size of a market (number of companies, investments, revenue, etc.), and then step-by-step narrowing down the focus to the segments that are relevant for your business depending on a number of assumptions and facts that support your estimate. Top-down can also include factors such as macro-economic conditions, competitiveness, the market size of competitors, etc.


Bottom-up typically starts by looking at quantifying specific customer segments one at a time, and then in aggregate numbers determine the size of a market. In this way, step-by-step increasing and widening the focus, a detailed picture emerges of the larger opportunity and the components and boundaries of a market. Compared to the Top-down approach, Bottom-up is typically much more time-consuming, but tends to yields a more reliable and higher-quality estimate of a market.

Total Market Potential, TAM, SAM, and ESAM.


When estimating and describing the size of a market, the below terms and concepts are often found:


  • Total Market Potential (Total Market). Describes the potential sales value of a product or service within a specific market over a specified timeframe. Total Market = # of Opportunities x Average Sales Price of Opportunities.

  • Total Addressable Market (TAM). Describes the potential sales value of a product in what is considered an addressable part of the market over a specific timeframe. TAM = Total Market x % of the Market or Segment that considered addressable.

  • Segment Addressable Market (SAM). Describes the potential sales value of a specific target segment in a market over a specific time frame in regards to the company's strategy, business model and delivery capabilities for that particular segment. SAM = TAM x % of Targetable Opportunities specific to a Business Model or Strategy.

  • Expected Share of Addressable Market (ESAM). Describes the portion of SAM which a company expects to be won for its product or service over a specific time frame. ESAM = SAM x % Expected Win Rate.


Going from top to down, from Total Market to ESAM, the estimated market size narrows down significantly. While Total Market can reasonably quickly be estimated or gained from a market or industry report, estimating SAM and ESAM is usually much more time and resource consuming. While Total Market can be vague and tends to be a large and debatable number, SAM and ESAM are more specific and concrete. The value of narrowing down the focus to SAM and ESAM is that the figures tend to become more tangible and realistic as they are more thought through and viewed through the segmentation prism as well as the company's specific strategy and business model. Worth noting is that each term has its own set of limitations, assumptions and benefits; but each holds its own weight when considering and estimating market sizes and market assumptions.


Time and Resource Constraints


When looking at a market and its segments to select which to target first, time and resource constraints should be included in the decision-process. In most cases, pursuing all market segments simultaneously is not possible due to limitations in available time, resources and maintaining of quality indicators. As such, it's crucial to determine which segment to start with, the reasons why, and the reasons why the other segments should wait. The selection of which segment to start with should not only consider the segment size and value; but also, how strong your product-market-fit is in the specific segment and how you can use your presence in the selected segment as a base for further expansion. As you should be able to see now, the extension and fulfilling of your product-road-map gains importance as it will need to be tailored to the segments you intend to capture along your growth journey from one segment to another. This is why your strategy, business model, and value proposition are critical elements when considering market segments, SAM and ESAM.


Recommendations


When considering to investing in a new market, product or feature - and especially when raising capital - the more specific you can be in terms of your market estimates and segments the better.


While big numbers measurements such as Total Market Potential may give an overview of the larger opportunity, it is the more tangible and specific SAM and ESAM that will help you to gain your investors' confidence in your assumptions, estimations and plans.


Investing for the future (project, product, feature, market) is always fraught with risk, and a strategy to reduce risks is to base your plans on tangible and realistic assumptions and numbers. Is it worth spending the time and effort to research and quantify ESAM and SAM? To a certain degree, yes, especially if you expect others to invest their money and buy into your plan.