Introduction to Scenario Analysis
Scenario Analysis represents the process of calculating an estimation model under a variety of scenarios for the future. The idea behind this analysis method is to assess the effect of risk on values in a financial model. Scenario Analysis helps us outline how realistic are the assumptions in our model and test its accuracy and robustness.
This method of financial model analysis is particularly useful when there are potential specific favorable or unfavorable events that can have an impact on the business or the environment in which it operates. We mostly use it as part of the management’s decision-making process.
The method can be used to analyze the potential outcomes of individual decisions. This usually includes benefits and issues that may exist in one option, compared to other options. Through Scenario Analysis, we can determine the amount of risk we are taking before making an investment or starting a new project.
Types of Scenarios
When preparing our analysis, we consider the possible future states of the business, environment, industry, and economy as a whole. We form our scenarios based on these possible sets of assumptions for customer metrics, operating costs, financing costs, inflation and tax rates, pricing policies, and others.
Usually, we would look at three scenarios at least:
- Best Case Scenario – this is our ideal situation, where all assumptions are at the best possible value – highest growth rate, lowest financing and tax rates, and others;
- Base Case Scenario – we consider this the average scenario, the most likely to occur values of the input variables, based on our average assumptions;
- Worst Case Scenario – the most severe adverse outcome for the model, complete opposite to the best-case scenario.
In some cases, we might add additional scenarios to take into consideration possible input variations due to unpredictable events such as:
- Competitors entering the market may squeeze the margins and force us to lower prices;
- Foreign exchange rates can have an impact on selling prices or cost of supplies;
- Changes in legislation may affect the company, pricing, material supply, and others.
Scenario Analysis and Sensitivity Analysis
People often mistake Scenario and Sensitivity Analysis. Both methods follow the same concept to predict outcomes based on given changes in input variables, but they differ a lot. Sensitivity shows the effect of a particular set of independent inputs on a dependent output, while Scenario Analysis requires a whole discrete scenario to be prepared by the analyst.
Building a Scenario Analysis in a Financial Model
To better understand the Scenario Analysis method, let us take our example Free Cash Flow projection model from our Sensitivity Analysis article (you can download the model at the end of this post).
Once we have our model, we will add the option to select the Assumptions Scenario. To achieve it, we will use the hlookup function to choose the values of one of our three scenarios (Best, Base and Worst).
Since we have already linked our model to the assumptions table, changing our Scenario selection will effectively replace all calculations in the model.
At our Base Case scenario, we get the following Free Cash Flow.
Going further down, we can calculate Net Present Value and the Equity Value, giving us a Share price of 6.26.
Switching to the Best Case scenario, our assumptions table updates with the respective input values.
Further down, our whole model is updated automatically.
The Net Present and Equity Value calculations also update, and we can see that in the best possible situation we will arrive at a share price of 10.30.
The same goes for the Worst Case Scenario. Once we change our selection, the assumptions update, and we get the following Share price.
We can compare the three results we get. If we have set up our assumptions and model logic correctly, the best case price per share should be the most significant value, and the base case share price should be between the best and worst cases.
Performing such scenario analysis can help us identify errors in the business logic driving our model, which are harder to identify when simply checking formulas. It can also help us present a range of results that we can use for the decision-making process, instead of just a single value that is highly unlikely to be achieved.
Benefits of Scenario Analysis
There are many reasons to do scenario analysis in our financial models. The future is quite uncertain and risky to predict, so we need to look at all possible cases, within reason.
- Future Planning
The method lets us peek into possible future performances, to make a better-informed decision where to invest, or what project to start;
- Projecting Measurable Data
It calculates the potential profit or loss of a project or investment, on which we can base our approach;
- Avoiding Failure and Mitigating Risk
Scenario Analysis allows us to assess opportunities and avoid poor investment decisions by showing us the best and worst cases so that we can make an informed decision;
Accurately assessing worst-case scenarios proactively to decrease unfavorable outcomes from uncontrollable factors can make or break our financial model, plus it’s often better to be proactive than reactive.
Issues with Scenario Analysis
As most of the financial modeling techniques we have looked at so far, Scenario Analysis has some disadvantages and drawbacks:
- Cognitive Bias
The human brain is wired to consider the most common scenario the most likely to occur. Therefore, we are biased to make decisions based on average situations, which can lead to the business using poor models in the decision-making process;
- Unpredictable Success
No matter how detailed our analysis is and how many assumptions we consider, we never know if a forecasted scenario will play out exactly as we had foreseen it;
- Continuous Improvement, Revision & Refinement
A scenario we believe plausible today may be less applicable in a few months. We must regularly review and update our scenarios to enable us to get the maximum benefit out of our Scenario Analysis;
- Scenario Analysis is a time-consuming process that demands high expertise and skill, which can often mean that we require more resources than available;
- Preparing appropriate forecasts is painful. The actual outcome may be entirely unexpected and not foreseen in our financial model;
- It is hard to envision all possible scenarios and assign them with probabilities and the appropriate risk levels.
Scenario Analysis is an excellent way to flush out anomalies in our financial models. It can be helpful to find out if we have some errors in our business logic, and these are usually harder to find than technical faults.
By combining Scenario Analysis with stress-testing and sensitivity analysis, we can build a more robust and rigorous model, one that can cope with variations in our input assumptions.
Don’t forget to download the sample Excel file attached below.
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