How can scenario analysis improve your discounted cash flow analysis?

Scenario analysis can enhance discounted cash flow (DCF) analysis by providing a more comprehensive understanding of the potential outcomes and risks associated with a particular investment or business decision. Here's how scenario analysis can improve DCF analysis: 1. Risk Assessment: By considering various scenarios, you can identify and quantify potential risks and uncertainties 2. Sensitivity Analysis: Identifying which assumptions have the most significant impact on the DCF valuation allows for a more focused risk management strategy. 3. Optimistic and Pessimistic Scenarios: understanding the range of potential outcomes.

Lastimosamente para quienes evaluamos proyectos, empresas, unidades de negocios, entre otros; modelar de los posibles resultados financieros no se puede circunscribir a un solo posible resultado. La dinámica competitiva aunado a la incertidumbre local o global, hace necesario el uso del muy famoso “what if” dentro de la ecuación de análisis. El tratar de responder todas las posibles interrogantes es una tarea imposible, por eso la necesidad se establecer escenarios que reflejen posibles coyunturas y que tengan una ponderación asociada a su ocurrencia para que pueda determinar cual paso se pudiera seguir. El arte de predecir el futuro, se sustenta, en los actuales momentos, en los posibles escenarios que consigamos como probables.

Lastimosamente para quienes evaluamos proyectos, empresas, unidades de negocios, entre otros; modelar de los posibles resultados financieros no se puede circunscribir a un solo posible resultado. La dinámica competitiva aunado a la incertidumbre local o global, hace necesario el uso del muy famoso “what if” dentro de la ecuación de análisis. El tratar de responder todas las posibles interrogantes es una tarea imposible, por eso la necesidad se establecer escenarios que reflejen posibles coyunturas y que tengan una ponderación asociada a su ocurrencia para que pueda determinar cual paso se pudiera seguir. El arte de predecir el futuro, se sustenta, en los actuales momentos, en los posibles escenarios que consigamos como probables.

In my experience, this is the amazing activity throughout the finance and forecasting field. In finance, forecasting, risk assessment this is the useful technique. E.g. Whether to built or lease scenario, requires the pros & cons of building a place or just lease it. In finance, it’s most useful in credit disbursal & cashflow projection for long projects. It works parallel with SWOT analysis of the entities.

Scenario analysis can enhance discounted cash flow (DCF) analysis by providing insights into the potential impact of different future scenarios on the cash flows and valuation of a project or investment. By considering various scenarios, such as different market conditions, economic environments, or business outcomes, analysts can better understand the range of possible outcomes and assess the risk associated with the investment. This can help in making more informed decisions and adjustment of assumptions or mitigate risks that capitalizes on opportunities identified through the analysis.

One should incorporate scenario analysis with rational assumptions as it allows us to gauge the uncertainty in the future economy. This helps the stakeholders understand the impact of the overall economic and/or industry-specific conditions on the businesses. Ideally, while performing the valuation, one should account for not less than 3 scenarios as follows: 1. Base Case: It represents the scenario where the economy is expected to expand at a stable rate and no unforeseen economic circumstances are anticipated 2. Upside Case: It represents the scenario where the economy is expected to expand at an exponential rate 3. Downside Case: It represents the scenario where the economy is expected to shrink or expand at a relatively lower rate

Riesgo de incertidumbre son caras de la misma moneda. El Análisis de escenarios es una herramienta que ayuda a hacer mas robusto el análisis de los flujos de caja. Tomarlos en cuenta no es tarea fácil ya que por lo general se considera 3 solamente, positivo, negativo y más probable. Si el modelo de flujo de caja está bien construido, los indicadores claves de valor o key value drivers expondrán a través de los escenarios, su sensibilidad ante las señales de riesgo, pudiendo así tomar acciones y decisiones más acertadas y con mayor base que si no se usaran los escenarios.

Riesgo de incertidumbre son caras de la misma moneda. El Análisis de escenarios es una herramienta que ayuda a hacer mas robusto el análisis de los flujos de caja. Tomarlos en cuenta no es tarea fácil ya que por lo general se considera 3 solamente, positivo, negativo y más probable. Si el modelo de flujo de caja está bien construido, los indicadores claves de valor o key value drivers expondrán a través de los escenarios, su sensibilidad ante las señales de riesgo, pudiendo así tomar acciones y decisiones más acertadas y con mayor base que si no se usaran los escenarios.

Riesgo de incertidumbre son caras de la misma moneda. El Análisis de escenarios es una herramienta que ayuda a hacer mas robusto el análisis de los flujos de caja. Tomarlos en cuenta no es tarea fácil ya que por lo general se considera 3 solamente, positivo, negativo y más probable. Si el modelo de flujo de caja está bien construido, los indicadores claves de valor o key value drivers expondrán a través de los escenarios, su sensibilidad ante las señales de riesgo, pudiendo así tomar acciones y decisiones más acertadas y con mayor base que si no se usaran los escenarios.

In my experience there are various ways of constructing the scenarios. I've often found scenarios most useful when they are linked to specific opportunities and/or risks regarding the company or asset under consideration. For example I have previously created scenarios based on differing assumptions for revenue generation from key products for a company, which would significantly alter the free cash flow generated. This gave insights into the importance of the revenue stream for the valuation. As two other examples, I've also looked at scenarios around cost efficiencies and macroeconomic growth, where the importance of those to the company's strategy and performance were of interest for the valuation.

Think of your DCF as a crystal ball, but instead of just one blurry future, scenario analysis gives you a whole cabinet of crystal balls, each showing a different possible outcome. It's like having a reality TV show for your investment, with drama, suspense, and a surprise twist ending! Instead of just one "happily ever after" forecast, you get to see how your investment might fare in a bull market bonanza, a recession rollercoaster, or even a zombie apocalypse. This lets you identify potential risks and opportunities you might have missed, and make sure your investment decisions are ready for whatever the future throws your way. So, ditch the old crystal ball and grab that shiny cabinet of scenarios - your DCF analysis will say thanks.

Done well, scenario planning ultimately provides decision makers with a broader range of insights to make key business decisions. By understanding how different factors can influence numbers in different ways, you help guide decision makers to having a greater understanding of the situation. A real modelling superpower when done well!

An example of the DCF scenario will be, for running a pharmacy store if we need to calculate DCFs we need to check it as per season. But once we have multiple scenarios that it can perform @90% , 85%, 75% and checking of results make really a good difference. Further scenarios can be a flu season vs a non flu season, vaccination ratio changes etc. The scenario can be based upon combination of two - three categories also to look overall impact on Cashflow’s. That’s how it helps in analysis and decision making.

I think one key limitation with scenario analysis can be tied to the tools you are using. More and more businesses I speak to want to utilise scenario planning in more complex ways. You need to make sure you have the right tools in place to get it done well. And when you are dealing with complexity and large numbers, getting it right with technology can have huge ROI!

It should be summarised and well presented to be effective in use for management for decision making . It’s always helpful in critical thinking and having right thing in hand.

Always think about the end-users of the information when working with scenario planning - especially those who will use the information to make decisions!