Explained: Role of sensitivity analysis and scenario analysis in equity valuation
A sneak peek into the role of sensitivity analysis and scenario analysis play in equity valuation.
Along with various approaches used for the valuation of equity, there is a significant degree of uncertainty involved regardless of the valuation approach used. The future is inherently uncertain and valuing businesses requires making assumptions about the future. Taking into consideration this uncertainty, an effective analysis must consider scenarios in addition to the most likely “base case” result.
Sensitivity analysis involves changing one assumption at a time to see the effect on the estimate of intrinsic value. To explain with an example, analysts might examine the impact of a different revenue growth rate on the company’s valuation. On the other hand, scenario analysis works with the same goal but involves changing multiple assumptions at the same time. For example, analysts might simultaneously change assumptions for revenue growth, operating margin, and capital investment. Either sensitivity analysis or scenario analysis can be used to determine a range of potential intrinsic value estimates based on a variety of different assumptions about the future. Either of the tools can be used by analysts to estimate the effect on a company’s valuation of different assumptions for economic growth, for inflation, for the success of a particular product, and so on.
The degree of uncertainty also varies in the case of value estimates. Companies bearing large, mature, slow-growing, non-cyclical businesses with well-capitalized balance sheets may be relatively easy to value. In this case, intrinsic value estimates from upside and downside scenarios may be close to the base case. In contrast, for new ventures and the companies exposed to technological or regulatory change, companies with significant operating or financial leverage, the range of potential intrinsic value estimates is likely to be much wider. In this case, analysts are likely to be less confident in making an investment recommendation without substantial confidence that intrinsic value differs markedly from the market price.
Analysts are expected to view their valuations as a range of possibilities instead of an estimate at a single point. For most companies, the range will be approximately symmetrical and might be imagined as a bell curve. The base case estimate of intrinsic value would be at the middle of the distribution with similar probabilities of upside and downside outcomes depending upon the judgement of analysts. The width of the tails will be based on a level of uncertainty pertaining to forecasts. For example, the large, mature, slow-growing company would depict a steep distribution with relatively thin tails, representing a relatively low likelihood of extreme values. The probability distribution of estimates need not be symmetrical.
Scenario and sensitivity analysis helps a financial modeller to identify and understand the crucial drivers of a project or business. In addition to this, one needs to understand the project or business’s capability of withstanding various scenarios, such as a downturn in the economy. Recent economic activity has shown that these changes can happen suddenly and drastically, which makes scenario analysis more important than ever.