How to Evaluate TAM: An Alternate Framework

In the startup world, the best way to become a Hare and get a high valuation is to talk up the giant total addressable market (TAM) of your product. Nothing gets a tech investor more excited than a company with bold plans to take over the world!

Rational people often realize these dreams are more poorly written fiction than practical ambitions. In the insuretech landscape, we see companies like Lemonade cavalierly throw out markets they plan to conquer from pet insurance to life insurance to auto and travel insurance and beyond!

Most people I think see through this nonsense. However, many investors tend to fall for the hype over the main market the company is targeting. In Lemonade’s case this would be rental and homeowners. For Root, there is auto insurance.

These are big, giant markets and surely it’s possible to fantasize one of these companies capturing 10% or more of the market someday, right??? Maybe, but that’s lazy analysis that needs to be tested.

Introducing ATAM

A more practical approach would be to look at what percentage of the market a company can realistically address. As an example, let’s take Mercury.

Mercury has done very well in auto in California for decades. An optimist might say Mercury’s TAM is the entire US auto (and home) market.

However, Mercury has been around for 60 years and they are only in eleven states and have generally struggled to find success outside their home market. Their effective TAM is a lot closer to California’s total personal lines premium than the national TAM.

Similarly, a company that only sells through independent agents has a TAM of the total US market * the % of the market served by IAs. Sure, there is a small possibility the company can evolve and expand its distribution, but it’s such a low probability that it is not worth ascribing any value to.

Thus, investors should focus less on broad unachievable TAMs and more on the parts of the market that will actually consider the company’s offering. I call this metric attainable total addressable market, or ATAM.

This better reflects the market share the company can hope to achieve and allows for better comparison of business models.

Lemonade’s Homeowners ATAM

For an example, let’s start with Lemonade. I’m going to put to the side for now any discussion of pet insurance or other line extensions, but you can apply the same framework to them.

Let’s start briefly with renter’s insurance. I will support that Lemonade probably has a 100% ATAM for the renter’s market. However, as we know, that is a small market. The real debate on the company’s future is whether it will succeed in homeowners.

While the company might have you believe all homeowners will consider them, I can tell you for a fact this is not true. I have no interest in trusting my home to a new company without a strong claims paying rating or a history of handling complex claims.

Furthermore, I would assert many people feel the same as I do, particularly people who have nicer homes or who have had prior claims or live in areas where catastrophic risk is above average.

Additionally, many people don’t want to trust their home insurance to an app. Rather, they want an agent who they have a relationship with and can call if something goes wrong.

The self directed market for homeowners is presently pretty small and is closer to Lemonade’s actual ATAM. However, it’s probably even smaller. We know their book is overweight urban renters and they are currently targeting condo buyers.

This suggests their ATAM is the subset of urban or major media market, suburban dwelling, self directed, younger homeowners. That’s a pretty small number in all likelihood and limits their growth potential.

Root’s Auto ATAM

Again, for now, I will sideline Root’s ambitions in other products to focus on the auto core. While they may think every driver in America could be a potential customer, I don’t see it that away. Again, I would never be. I don’t want to buy my insurance through an app that is going to spy on my driving.

Root’s target market is younger drivers who are comfortable buying on a mobile device and don’t mind sharing personal data. That sounds an awful lot like the non-standard auto market. That’s a lot smaller ATAM than every American driver.

Now, one could argue, didn’t Progressive start off in non-standard and move up market over time? Yes, over time. Like decades.

If that is your investment horizon, then by all means, ascribe a larger ATAM to Root. However, in a reasonable investment horizon, their ATAM is something like 20% of the US auto market.

The other objection is probably, yes, but as millennials age, they will stay with Root and this is how the whole market will buy! Maybe, but again, that takes decades, and it also ignores human nature.

Why does Progressive run those commercials about becoming your parents? Because people care about different things as they age. They will likely want more from their auto insurer than just a driving score. Sure, Root can adapt to that as it matures, but will their competitive advantage remain? Not everyone can execute like Progressive.

Introducing PTAM

There’s another important issue beyond addressing a realistic addressable market. This is going to sound obvious, but it is so often ignored. You have to be able to make a profit in your chosen market!

Airlines have giant TAMs! Who cares? They can’t make money! Automakers sell like $500B of metal. What is their combined market cap?

TAM is an irrelevant metric. What matters is the profit you can make off your TAM, now to be known as PTAM (or profit TAM).

Would you rather address a $1T market where you could only achieve 1% profit margins or a $50B market with 25% profit margins? The first has a $10B PTAM while the smaller market’s PTAM is $12.5B.

You can make an argument for preferring the former (for example, if you believed you could get a much higher market share in the former than the latter) but, for the most part, the latter is going to be more appealing (especially if you care about things like return on capital, rather that just $ of profit).

Too many startups fail to even address their PTAM. For instance, we know Progressive targets a 96 CR in auto. We know many other companies’ ROE targets.

Nowhere in their prospectuses did Lemonade or Root suggest what their ultimate margin goals are or even when they will be profitable on their phony pro forma metrics. Why not? Because they are so enamored with expanding their TAM, they won’t even consider what their ultimate PTAM should be.

The DoorDash Case Study

I’ll admit, I’m not up to date with the market dynamics in the food delivery space. All I know is Uber and most of the others lose a lot of money and it seems an expensive service relative to the value.

Thus, I was curious to look at the DoorDash IPO S-1. I was actually pleasantly surprised! It also happens to be a great case study for today’s lesson.

DoorDash has a different focus than its peers. By being largely suburban, it is limiting its TAM, but creating a bigger ATAM. Doordash has ceded much of the growth in cities to the competition, but it has a better mousetrap for the suburbs allowing it to expand its ATAM.

We believe that suburban markets and smaller metropolitan areas have experienced significantly higher growth compared to larger metropolitan markets because these smaller markets have been historically underserved by merchants and platforms that enable on-demand delivery. Accordingly, residents in these markets are more acutely impacted by the lack of alternatives and the inconvenience posed by distance and the need to drive to merchants, and therefore, consumers in these markets derive greater benefit from on-demand delivery. Additionally, suburban markets are attractive as consumers in these markets are more likely to be families who order more items per order. Lighter traffic and easier parking also mean that Dashers can serve these markets more efficiently.

DoorDash S-1 p.10 (emphasis added)

Even though DoorDash has a smaller TAM, it has the top market share in the food delivery space! It has such a big lead in its ATAM that it can afford to cede more competitive segments of the market. This is what’s known as having a strategy!

But it gets better! Not only does DoorDash have the biggest share, it also is the most profitable (more on this below) as – as noted above – their customers are less price sensitive and order higher average tickets while the drivers can be more productive.

Even better than that , their retention is best in class. Look at the chart below. Most of their revenue comes from recurring customers! This is something insuretechs can only dream of.

Because of the strong retention, DoorDash’s customer acquisition costs are quite favorable. For the insuretech investor who thinks this number should be 50% or even 100% of revenue, the chart below is not a misprint. Yes, that is 2% recurring acquisition cost.

What does all this mean? They have unit economics that make sense! The below graph shows their profit margin before fixed costs. In other words, it’s basically revenue less what they pay the drivers less marketing spend.

In insurance terms, we would call this a technical ratio. There is no “adjusted gross profit” that ignores giant costs like customer acquisition!

So a customer loses $ year one due to the upfront acquisition spend, but then is profitable at “renewal”. That sounds like a sustainable business model! This is what every insuretech should be emulating!

Am I suggesting you should buy the DASH IPO? I have no opinion on that. However, these are the types of financial characteristics I would want to see in an IPO of a young growth company before I would consider buying it.

What Have We Learned?

Sustainable business models ultimately have to maximize PTAM. The best way to maximize PTAM is likely to be having a high share in an ATAM with good margins rather than low margins and low share in a giant TAM.

None of the above is groundbreaking insight, nor should it be controversial. However, it has been largely dismissed in recent years.

Remember one of the lessons of the Hare: most Hares fool themselves into thinking they can chase a big TAM and achieve high profits. That’s why more Hares fail than Tortoises.

It’s also why Hares have to focus on creating a cheap cost of capital by playing up their large TAM to offset their inherent PTAM disadvantage. But what happens if investors become smarter and begin to prefer focused PTAM stories over giant TAM stories with no visible PTAM prospects??? Maybe someday we’ll find out!