Addressable Market

The addressable market answers a simple question: How much money do customers spend in total on a certain type of product? What’s meant is the sum across all buyers who could conceivably be considered for this product. A company that sells software for dental practices therefore calculates how many dental practices exist and how much each of them would pay for such software. If the result is 60,000 practices and 3,000 euros per year, the addressable market amounts to 180 million euros per year. This figure is explicitly an upper limit. No company ever gets all customers, because there are competitors and many practices simply stick with their old solution.

Why investors ask about this figure first

Anyone who invests in a young company is not buying today’s profits but a hope for future ones. This hope has a natural boundary: no company can become bigger than its market. That’s why the figure appears in nearly every presentation with which founders raise money. A start-up with an excellent product in a market worth 20 million euros is uninteresting to major investors, even if it does everything right.

At AI companies, the figures cited turn out to be especially large, and there’s a reason for that. Providers of language models don’t calculate the market for software for themselves, but rather a portion of worldwide spending on office work right away. The reasoning goes: If a program takes over tasks for which people were previously paid, then their salary is the actual market. This is how estimates in the trillions come about.

But this is exactly where the term’s biggest weakness lies. The figure can be inflated almost arbitrarily depending on how the definition is chosen. A critical reader therefore always checks which customers were counted and whether they would really be willing to spend money.

From the world population to a realistic customer base

Three levels are common, each becoming narrower. The outermost is called TAM, Total Addressable Market: all spending worldwide on this product category. The middle one is called SAM, Serviceable Addressable Market: only the portion of that which the company could actually serve with its offering and in its markets. The innermost is called SOM and refers to the share one realistically aims to win over the next few years.

This is calculated in two ways. The top-down approach takes a study from a market research firm and cuts out a slice of it. This is quick but imprecise, because the study usually answered a different question. The bottom-up approach instead counts from below: number of possible customers times price per customer per year. This calculation is more laborious, but every step can be verified.

A common mistake is treating the addressable market as a fixed quantity. It changes when prices or technology change. If the price drops sharply, suddenly far more customers can afford the product, and the market grows. This is exactly what is currently happening with AI services, whose operating costs have been falling for years.

The figure in stock market news and quarterly reports

In business news, the term usually appears when a company needs to justify a jump in its share price. Sentences like “our addressable market is growing to 500 billion dollars” are standard in analyst conferences held by chip and software companies. The figure also appears in the prospectus during IPOs, because it is meant to make the demanded company valuation plausible.

As a reader, a simple test is worthwhile. Divide the current annual revenue by the stated market size. If the result is a fraction of one percent, the figure is either a genuine opportunity or simply too generously estimated. Comparing the same company over several years also reveals when the market definition has been quietly expanded.