About a year ago, we put out a newsletter that was widely acclaimed for its detailed coverage of our investment approach outlining what we look for in early stage firms we seek to support. A following newsletter elaborated on the most important factor, from our point of view, the team. In this letter, we are sharing our views on the second most important factor that attracts us: a sizeable market opportunity.
Let us cite the gist of what we had shared in our prior newsletter: we like to see ideas and businesses that are addressing a pretty sizeable market. The key is to employ scientific research in figuring out, upfront, how big the addressable market is. Entrepreneurs who take the trouble of estimating their addressable market size, use a few mechanisms as outlined in the table below:
Once they have an idea of how large the addressable market is, they can dissect this large market and figure out which part of the market should be addressed first and why.
Let us focus on the commonly used Total Addressable Market (TAM). At Equanimity, we have seen over 3000 companies in the last 18 months and most of their decks touch upon the total addressable market that their product or service can target. There are a variety of ways in which TAM can be calculated and a cursory google search can yield a few of these methodologies. We would like to highlight just one aspect of TAM that is typically missed by early stage firms: shareholder value. Can the return on investment be greater than the cost of capital as the business grows? We encourage startups to think about how large can their business grow to while still creating shareholder value. The minute we introduce this aspect, conversations between investors and entrepreneurs gets more focused on the value drivers of the business and how they will remain relevant as the business scales up. It forces all stakeholders to think a lot deeper than mere lip service to the concept of TAM that is displayed in large number of billion of dollars in large fonts in most pitch decks. This is the other aspect that we experience frequently: optimism and overconfidence are at display in most pitch decks that talk about TAM. It is only when we start digging deeper that we arrive at a discount rate or a factor of overshooting that needs to be applied to the TAM bandied about in presentations.
When we analyse traditional and mature listed market industries like steel, cement, industrials, etc. analysts have a broad idea of the overall existing market size and a typical or anticipated growth rate of that sector. The TAM question then becomes one of how much of the existing market and the anticipated growth can the business under diligence capture. Equanimity invests in early stage technology enabled businesses that are typically creating newer markets or are disrupting existing markets using new age business models. This makes the work of arriving at TAM a tad more difficult. It brings in a level of crystal ball gazing a notch higher than what is adopted while evaluating market sizes for traditional industries. Let’s put together a simple 2x2 matrix to understand this:
While we deal with 3 of the 4 quadrants (no prizes for figuring out that we don’t deal with the current market/current technology quadrant), as we move towards assessing TAM for Quadrant 1: New technology/New market businesses, the estimation challenge escalates. At this stage, we do not know the adoption rate either for early adopters or for the ultimate adopters for the company’s offerings. We also do not know the adoption rate and its pace as it grows which is a variable that can put the most savvy forecasters to shame. Here are some technologies and their adoption rates over the years:
It is evident that with the advent of technology and as a direct consequence of the much talked about network effect, time taken for adoption of new technologies is shrinking rapidly.
Allow us to humour you a bit and share some recent expert snippets that turned out to be an embarrassment for the person who made that statement or forecast:
1. “Neither Redbox nor Netflix are even on the radar screen in terms of competition.” - Jim Keyes, CEO of Blockbuster, speaking with The Motley Fool in 2008
2. “I strongly do not believe that they [AirBnb] are a major threat to the core value proposition we have.” - Christopher Nassetta, CEO of Hilton Hotels, on speaking with CNN in 2015
3. “[These mobile games are] candidly disposable from a consumer standpoint.” - Reggie Fils-Aime, President of Nintendo, on speaking with GameTrailersTV in 2011, defending Nintendo 3DS’ more expensive games
4. “We have learned and struggled for a few years here figuring out how to make a decent phone…PC guys are not going to just figure this out. They’re not going to just walk in.” - Ed Colligan, CEO of Palm, in 2006, after getting the news that Apple was developing a phone
5. “We do not believe our vendors selling product on Amazon directly is an imminent threat. There is no indication that any of our vendors intend to sell premium athletic product, $100 plus sneakers that we offer, directly via that sort of distribution channel.” - Richard Johnson, CEO of Footlocker, on an earnings call in August 2017
What more lesson do we need in humility!!
That said, here is a simple thumb rule that can be used for estimating TAM:
Step 1: Estimate overall population. Here we mean relevant population not the general overall population.
Step 2: Adoption rates can now be estimated keeping in mind the product/service price points, distribution channels, product features, etc.
Step 3: We now simply multiply price with the volume estimate to arrive at TAM.
Let us illustrate this simple process using the example of the recently announced WhatsApp Pay.
Step 1: With a population of 1.4 billion people, mobile penetration in India stands at ~1 billion.
Step 2: Assuming an adoption rate of ~45%, which indicates that 45% of the mobile subscribers use one of the digital wallets to transact online
Step 3: We can use industry comparables of 2 transactions per user per month and $20/transaction to arrive at a market size of ~US$200 billion.
When we want to do an in-depth TAM analysis, it pays to focus on factors we learn in Economics 101 - demand and supply. When estimating demand, we have to understand the influence of pricing and overall share of wallet that the consumer will have to pay for a product/service. We have to pay attention to demand elasticity to figure out how demand will change with any change in price. Substitutes can play a role here and it becomes important to understand the current and impending technology changes and offerings that can impact demand. Seasonality and cyclicality have to be borne in mind before we extrapolate current findings to estimate sustainable demand. Geographical spread - local/national/global, current and in future, plays a role in determining demand size and whether supply can meet this demand. When estimating supply, we have to evaluate capacity, capacity utilisation and the ability to supply. Price and pricing power is also an important criteria especially if businesses use it to achieve scale via network effects. Regulations are a real variable in quite a number of businesses and can impede supply by having a say in pricing, licenses, capital requirements, etc.
The overriding approach to any forecasting is to minimise the number of variables estimated. In our experience, the lower the number of assumptions the lower the probability of the estimate being far away from the eventual actual number. We tend to prefer this approach in the TAM estimation exercise when we evaluate and analyse companies. It has always stood us in good stead.