Sensitivity & Scenario Analysis
Sensitivity and Scenario analyses are techniques used to assess how changes in key assumptions (e.g., discount rates, growth rates, or margins) affect a valuation or investment outcome. They help analysts and decision-makers understand the range of possible results and gauge the risks associated with uncertainties in forecasts. By systematically varying assumptions, you gain insights into the robustness of your conclusions and can better plan for adverse or unexpected outcomes.
Sensitivity Analysis
Sensitivity Analysis focuses on changing one variable at a time while keeping others constant to see how it impacts a specific output (for instance, the net present value (NPV) or enterprise value in a DCF analysis).
Common Variables to Test
- Discount Rate (WACC or Cost of Equity)
How does a +1% or -1% shift in the discount rate impact valuation? - Terminal Growth Rate
Small changes to long-term growth assumptions can have a large effect on Terminal Value. - Revenue Growth
How sensitive is the valuation to modest changes in top-line growth? - Operating Margin
Future profitability assumptions also have a cascading effect on free cash flow.
Example Sensitivity Grid
Below is a simplified example of how you might set up a matrix for a DCF-based enterprise value depending on variations in the discount rate and terminal growth:
| g = 1% | g = 2% | g = 3% | |
|---|---|---|---|
| WACC = 9% | $1,200M | $1,300M | $1,420M |
| WACC = 10% | $1,000M | $1,100M | $1,200M |
| WACC = 11% | $900M | $980M | $1,050M |
- If you assume a WACC of 10% and g of 2%, you get an enterprise value of $1,100M.
- By scanning the grid, you see how a higher or lower discount rate or growth rate would alter the valuation.
Scenario Analysis
Scenario Analysis goes a step further by adjusting multiple variables simultaneously under different plausible future conditions (e.g., best case, base case, worst case).
Steps in Scenario Analysis
-
Identify Key Drivers
Determine the main variables that significantly affect your model (e.g., market size, pricing, cost structure, macroeconomic indicators). -
Define Scenarios
- Base Case: Your most realistic forecast with standard assumptions.
- Best Case: Optimistic scenario—higher growth, lower costs, favorable economic conditions.
- Worst Case: Pessimistic scenario—slower growth, higher costs, or economic downturn.
-
Adjust Inputs Accordingly
For each scenario, rewrite the assumptions around revenue, margins, capital expenditures, etc. -
Calculate the Outcome
The result might be an NPV, IRR, or an overall valuation range (e.g., $900M – $1,400M enterprise value).
Example Scenario Table
| Worst Case | Base Case | Best Case | |
|---|---|---|---|
| Revenue Growth | 3% | 5% | 8% |
| Operating Margin | 12% | 15% | 18% |
| WACC | 11% | 10% | 9% |
| Enterprise Value | $850M | $1,100M | $1,400M |
- Worst Case: Lower revenue growth, tighter margins, higher discount rate → $850M.
- Best Case: Higher revenue growth, stronger margins, lower discount rate → $1,400M.
Why These Analyses Matter
-
Risk Management
Pinpointing which variables most heavily impact your model helps you prioritize and mitigate risks. -
Decision-Making
A single-point estimate of valuation might be misleading. Ranges or scenario-based outcomes provide more robust guidance for corporate strategies, M&A deals, and investment decisions. -
Investor Communication
Presenting a range of outcomes can increase credibility and transparency with stakeholders.
- Sensitivity Analysis isolates the impact of one key assumption at a time.
- Scenario Analysis captures a holistic view by modifying several assumptions simultaneously.
Used together, these methods ensure you understand how changes in market conditions, costs, or strategic initiatives can affect your valuation or investment returns—essential for sound financial planning and risk assessment.