How to determine market size as a startup

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Market size is a critical factor when you set up a new business. It's a measure of the potential value in your chosen market, and so it gives you an idea of exactly how much money you can make from your innovation.

This has far-reaching implications. It not only tells you whether your business venture is viable, but can also help you to make decisions about how much to spend and whether to target a niche or try to serve the market as a whole.

It is also one of the headline figures investors will want to look at when they decide whether to put money into your business or not. Being able to show potential backers that there is an existing market of considerable size can make a huge difference in winning their support.

Market size - in terms of both volume and value - can change over time due to supply and demand trends, price inflation and currency exchange rates, so you should periodically update any calculations of your target market size.

How to evaluate market size

In a moment, we'll look at some of the different terms and definitions used when people discuss market size.

There are many different ways to define market size. Some of these are quite easy, while others take a more diverse range of influencing factors into account in an attempt to calculate a more useful or 'realistic' result.

It's rarely as simple as just adding up all the money spent by customers in a given sector. You have to decide which rival suppliers fall within the scope of your target market and which revenues to exclude from your calculations.

You might even want to evaluate market size across several distinct niches. For example, you might supply several different products with completely different customer bases.

By calculating your potential market value for each product or category, you can then combine these figures into a single market size. The result is directly relevant to your company, and you can use it to determine your share in a complex, multi-faceted customer base.

Why do we calculate market size?

Working out market size is the first step towards gaining a better understanding of your company's potential growth rate.

Market size is a many-layered metric. In any sector, there are likely to be parts that you cannot serve with your current offering of goods and services.

These unreachable parts still contribute to the total market, but it might be more useful to exclude them from your own measurements and calculations.

Equally so, the potential market you can serve can be refined further by factors like geographic area, creating smaller customer demographics within that overall possible value.

In the end, it's more important to get numbers that are useful to you and your investors than it is to compile a report that spans the entire global market for a product or service.

This is why many third-party analysts include chapters in their industry reports that focus on specific parts of the world or subcategories within a broad sector.

What do we mean by market size?

As is often the case in business, when we say market size, we can mean several different things.

On the one hand, you can use market size to refer to the total revenues generated by a specific sector, industry, niche or area.

But this is not always the most useful definition. Instead, you may want to calculate the total revenues available to your company - the market size you can realistically serve.

Give some thought to the most useful definition of market size for your needs. If you're not confident about handling complex calculations yet, a simple definition could be the best place to start.

As your business activities evolve, you might start to focus on specific high-growth niche markets. By doing so, you can refine your definition of your market size to produce numbers that are equally accurate but even more relevant.

What is market size?

In general, market size is simply the total amount of money customers spend on goods and services that fall within the definition of the relevant market.

That definition is open to some debate. Different analysts will include different parts of an industry's supply chain and may exclude or estimate market revenues for very small businesses within that sector.

The way you define the market can affect how useful the measure of market size is for you. Because of this, it's important always to know what definition the analyst used and not just what the final calculated figure is.

A natural starting point is TAM, which is the overall benchmark for any given market. We'll look at how to calculate TAM below and also how to move beyond it using more specific definitions.

How to calculate market size?

At its simplest, market size is just all of the money spent within the target market, added together to give an overall figure.

This is called Total Addressable Market, or TAM, which we'll look at in more detail below.

As mentioned above, TAM can give you an idea of how much money there is in your chosen sector, but it doesn't always mean those revenues are available to you.

By adjusting your definition of your target market, you can make sure you only include revenues that you have a chance of earning.

From there, you can go on to calculate the ratio of your revenues to the total possible market size, which gives you a measure of your market share.

Understanding market potential

Defining realistic market potential - and not just total market size - is a crucial step toward getting a better understanding of how well your company is performing.

If there is a large market sector but you only cater to a small niche within it, there can be a huge difference between market size and market potential.

While your annual revenues might be just a tiny percentage of the entire market, you might be tapping into a relatively high proportion of the real-terms market potential available to you.

As a result, your market share might be much higher than it initially appears, especially if you serve a niche market where you have good penetration and few direct competitors.

Why market potential matters

Knowing your market potential allows you to make much more realistic informed decisions as you will not be aiming to gain an increase in market share that is not possible to achieve.

You don't have to use just one definition of market potential. You can define market share in a number of different ways and at several different levels.

For example, as your business grows with time, you can broaden your market share formula as you enter new parts of the sector and bring new goods and services into your offering.

As your market potential increases, your sales revenues may rise even though your market share appears to remain static or even decrease.

It is the combination of these factors that matters - logically a smaller stake in a larger market can be as financially rewarding as a larger share in a very narrow niche sector.

Understanding market value

There are two important V-words when calculating market size. These are volume and value.

Market volume

Market volume is a measure of how many customers you can expect to acquire within the target market.

For example, if there are 2,000 customers in total and you have a market penetration of 50%, then your calculated market volume would be 1,000 companies or individuals.

The market volume formula is very simple: number of customers multiplied by penetration rate.

Remember that this is a measure of volume, i.e. the number of entities within the market, and not an estimate of value.

Market value

Once you have calculated market volume, it is relatively easy to turn that number into a measure of market value.

To do so, you simply multiply your volume figure by your average sales or forecasted revenues per customer.

This gives you an expected total sales value that can serve as a likely upper threshold for revenues, assuming you reach all of your targets in terms of average order value, penetration rate and the overall size of the market you serve.

Making more than market value

Because market value depends on certain estimates, it is not necessarily a precise figure for the maximum revenues that you can generate.

For example, if you achieve an average sales value greater than your estimate - perhaps because you find buyers are willing to pay more than expected for your product - this can filter through the calculations to result in a much higher real-terms market value.

However, your calculated market value is a 'best guess' based on market research and realistic projections, so that you have the information you need to make informed decisions about the way you run your company.

Understanding Total Addressable Market (TAM)

The acronym TAM stands for Total Addressable Market or Total Available Market. The two terms mean the same thing and you can use them interchangeably.

Knowing your TAM gives you an idea of how much money is available within your target market.

However, it's important to remember that you are unlikely to achieve close to the TAM figure, as your competitors will always take some market share.

But it is still a useful metric to keep in mind, as you can combine it with your revenues as a way to estimate your share of the market and identify potential for growth.

What is total addressable market?

TAM is a fairly simple statistic. It gives a total market size at any given time. You can use this as a reference point to judge how well your business is performing.

Investors might look to this figure as an example of the total potential in a niche market, so it's something you should keep in mind and try to update regularly.

There are different ways to define the scope of TAM. For example, you might want to calculate TAM for a specific niche market, a broader industry or sector, or a geographic area.

How to calculate the total addressable market?

To calculate TAM, you simply add together all the revenues generated by companies that fall within the scope of that calculation.

So that could include companies with headquarters, branch offices or other outlets within a geographic boundary, or all the businesses in a specific market.

TAM should be the largest figure for any given market. Other metrics, like Served Available Market and Share of Market, are smaller because it is very rare for a single company to occupy a 100% stake in one sector's revenues.

What about static market size?

It's rare for a market to be completely static. In most cases, TAM will rise and fall continually as new demand comes into the market and old suppliers cease trading.

Much of the change in market share comes from these dynamic forces:

  • New customers and fewer competitors drives market share higher
  • Fewer customers and new competitors puts market share under threat

However, there are times when you may encounter static market size or unusually stable market value overall.

You can recognize this as little to no change in TAM over time. If your business is already doing well in such a climate, you might be happy to keep your current market share.

If you are still looking to grow in a static market, the only way to do so is to take market share away from your competitors.

Doing this can be more difficult as you need to give their customers a reason to switch. This might mean offering a discount or other incentive.

Overall, your revenues may increase as you steal more market share during static times. But it's crucial to keep a close eye on the incentives you offer, so that you increase the net value of your business despite any discounting.

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