Market Size and Forecasting (I)

When looking at a new opportunity an investor needs to have a view on whether that opportunity is BIG and if it has prospects of rapid growth. VCs are obsessed with this, mainly because of the power law that rules most aspects of their business. In order to make up for the investments that do not go well, they need the outcomes of the ones that are successful to be as big as possible. Obviously, there are a variety of factors that need to work apart from market size, but we are going to focus on this one for now.

In my consulting work, I have done quite a bit of market sizing and forecasting, as it is important both for due diligence of investments and to see what the options are for any company. Let me share with you part of my approach.

When we are sizing a market, it is critical to distinguish the phase of the market in which we find ourselves, and tailor our approach to that phase. In terms of growth, one can differentiate markets which are in a phase of technology adoption (which implies rapid growth) and maturity (in which growth slows down). I will do a high level run-down of different approaches we can take depending on the market phase and characteristics. In future posts, we can discuss each of the approaches in more detail, and see examples of each of the approaches. For the sake of being instructive, let me move backward on the curve:

  1. Technologically mature markets: These are the more conventional markets, that are not going through technological disruptions of any kind. The sizing of these markets is straightforward, meaning you need to do your research and there is a good chance you will come to the number in a straightforward manner, without having to apply complex assumptions. The market size is usually broken down into price (P) and volume (Q). So, a typical approach would be to research the volume (restaurants in an area, number of taxis in a city, average consumption per household of a certain type of food, etc.) and then make and assumption on the average price or value per transaction. A good way to make this assumption is often to do mystery shopping, calling as many providers and possible and asking for prices. If it is a commoditized market, this part will be easier, as prices will not differ significantly between providers.

For forecasting these markets, we need to identify the underlying drivers that will make the market grow. There are several ways to do this, and varying levels of difficulty. Sometimes these drivers are macro (GDP, consumption, etc.) In that case, it is not hard to conduct a regression analysis and forecast the market as a function of its correlation with the macro drivers. But most of the times it is not as simple as that, with multiple drivers (both macro and more specific) having an impact. It is then difficult to have a standardized approach, you will have to think through every case. You didn’t think I would do all the work for you, right?

2. Markets going through technological disruption / transformation have a different dynamic, as several things can happen which have an impact in how we forecast the market. On the one hand, the new technology can impact the total size of the market, especially if it makes the product significantly cheaper. There is also a new driver which impacts growth and that is the penetration of the new technology. This means that growth is not only driven by demand for the product, but by the penetration of the technology over the total market, which is a lever that accelerates growth until penetration has reached its cap. When the product implies doing something that was already being done, but doing it better or differently, this is the way to go. One example would be the market of flat screen TVs over total TVs, or smartphones over total mobile phones.

3. Blue-sky markets: These are hard… These are the ones which require us to change the way we think about the market, because the potential it has is so much bigger than the obvious analysis of the current state of the market. It is more about TAM than about the actual market. More about the potential use of the product and the underlying demand for that use. There are a number of examples in history, but one which is illustrative is the market for cars. At the beginning, people thought it would be a substitute for horse-drawn carriages. It was difficult to make the leap to think about how it would change our lifes and our cities. Here is a another example of how Bill Gurley approaches this concept for Uber.

I could write many posts about market sizing… in fact, that is what I am going to do. It is an important topic and it is worth covering it extensively. So, coming up, several posts with more detail on each of the different approaches and examples to illustrate them.

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